"Camp wagon on a Texas roundup"
Ilargi: It’s becoming hard not to wonder if all these investors and speculators who are busy betting against Greece ever get that wake up sweat-drenched in the middle of the night feeling that someone's playing them for a bunch of fools. So, Greece is that bad off, huh? So much so that everybody's gaze is focused on Athens, even when its GDP is way smaller than more than a few US states. Can the Greek situation bring down the entire eurozone? That’s a major maybe, far too doubtful to bet the house on. I wouldn't underestimate the possibilty that, trying to start a fire in the Mediterranean, many a money manger will end up with burnt fingers. The herd in action, down the hill.
What does seem certain is that the costs of servicing and issuing debt will rise considerably for Greece and other weaklings among global nations, including the US and UK. And that may have far more far-reaching implications around the world than whether Greece is bailed out in some form or another. JP Morgan states that the UK is in as bad a shape financially as it was in the 1976, when the IMF was called in to bail it out, and that the pound sterling could see a "marked fall" in value on account of this. Britain should be so lucky. A currency can fall only relative to other currencies (if we leave gold and other commodities out of the equation for a moment).
And which currency would then have to rise vs the pound? The Euro? Hmmm, maybe not. The Yen? Maybe short-term, but Japan is not exactly the strongest sibling out there; it wouldn't take much for serious questions to be raised about the country. We can all spell Toyota. It won’t be the renminbi either, since China is dead in the water without its exports. That leaves only one major candidate, the US dollar. Which is also highly dependent on a weak currency, but will still be left holding the bag on this one unless it finds some ground-shifting way to beggar all of its global neighbors. Being the reserve currency is a two-faced coin.
It wouldn't surprise me one bit if the main consequence of the Greek issue as it plays out today is not the demise of that country, or of the Eurozone, but instead a dramatic acceleration of the world-wide financial truth-finding process that has been lying dormant far too long inside faked balance sheets, moldy bank vaults and make-’em-up-as-we-go accounting standards. Most of those theatrics can only exist as long as they're not exposed to daylight. And that's precisely what Greece may provide us with: a trigger to start a process, a reason to acquire a clearer view of reality.
What if the same speculators who now lay siege to the Parthenon turn their eyes towards Sacramento, Hanoi, Tokyo or London? Every single possible target will be required to show its strengths, and its weaknesses. And when put under actual pressure, will Greece turn out to be the weakest link in the entire chain? Will it offer the greatest rewards to the speculating crowd? Sure, if Germany saves Greece, there’ll more wounded lining up. But how is that different from Obama deciding to hand-feed California? Plenty other states would be at the door within seconds, if they're not already there.
These developments always tend to begin in unexpected places, the parts of the world where black swans lay their eggs. Is Greece unexpected enough for you?
Hugh Hendry bitchslaps Joe Stiglitz
(Oh, right, and the Spanish Ambassador..)
No Longer Too Big To Fail? Standard & Poor's Thinks So
The giant credit rating agency Standard & Poor's issued a stark warning Tuesday to creditors of Citigroup and Bank of America, two firms that up until now had been considered "Too Big To Fail". The message: We're not so sure the U.S. government will bail them out again next time. In the fall of 2008, the government ponied up $90 billion to rescue the two giant banks rather than risk the repercussions of their failure. Since then, the implicit guarantee that the government would backstop them has been hugely profitable to megabanks. For instance, they have been able to borrow money at cheaper rates because lending to them essentially carried no risk.
But now, Standard & Poor's is saying, the rules seem to be changing: "The outlook revision reflects our increased uncertainty about the U.S. government's willingness to provide additional extraordinary support to highly systemically important financial institutions in a way that benefits debt holders," the agency announced. "We previously stated our belief that the extraordinary support was temporary. We believe markets are beginning to stabilize and the U.S. government is seeking ways to reduce the potential for moral hazard and systemic risk associated with large financial institutions." So more than a year after a reckless Wall Street nearly brought down the U.S. economy, it appears the Obama administration and Congress have persuaded at least one credit-rating agency that taxpayers won't be there to support megabanks next time they screw up.
With its short statement, S&P put the market on notice that TBTF banks will no longer be able to enjoy the fruits of their risk-taking without having to suffer the consequences when their bets go sour. And the markets reacted accordingly. The cost of insuring the debt of Citigroup and Bank of America against restructuring or default rose 2.2 percent each Tuesday, according to CMA Datavision. In the 2008 crash, employees of Bank of America and Citigroup were laid off en masse and shareholders took a hit on their equity investments -- but the firms' creditors escaped as the bailouts preserved the value of their debt.
Last December, the House of Representatives passed a bill with zero Republican votes to ensure something like that never happens again. In short, should there ever be a situation in which a TBTF firm requires taxpayer assistance, the firm's bondholders will also take a hit -- a significant change from the present situation. "I'm pleased to see that they're taking our efforts seriously," said Rep. Brad Miller (D-N.C.), a member of the House Financial Services Committee. Miller helped push through an amendment calling for a firm's creditors to suffer losses should it need government assistance. S&P specifically mentioned that portion of the bill. "I hope we've made it clear that we're not going to stand behind the big firms forever," Miller said.
S&P also pointed to the Obama administration's recent efforts to curb TBTF, most notably its push to recoup taxpayer losses on the TARP program by imposing a levy on the biggest financial firms based on their leverage. "The subsequently proposed Financial Crisis Responsibility Fee, which would impose a significant cost burden on the largest banks, further underscores the extent to which the political climate may affect bond holders of these companies adversely," S&P said in its statement.
"The rationale that S&P provided here is on the money, particularly the phrase about 'seeking ways to reduce the potential for moral hazard and systemic risk associated with large financial institutions,'" said a senior administration official. "S&P is taking the moral hazard issue more seriously. They think the government is going to take stronger steps to deal with too-big-to-fail institutions, and they therefore see more risk," said Douglas Elliott, a former investment banker and currently a fellow in economic studies at the Brookings Institution, a Washington think tank. "The more we see things like the ratings agencies assuming that a too-big-to-fail institution could cause losses to creditors, the better it is," Elliott said. "If the Street is starting to read this as lending to these institutions is not completely safe, that's a great thing." He added: "These banks are highly-levered institutions. If debt holders start to care about their safety, that will translate into how management acts."
TBTF status brings a huge benefit to megabanks because the market treat their debt as fully guaranteed by the U.S. government. It's a massive taxpayer-funded subsidy. For example, in a September study, Dean Baker, co-director of the Center for Economic and Policy Research in Washington, D.C., and a colleague, calculated that since the failure of Lehman Brothers in September 2008 and the ensuing actions that enshrined TBTF, the 18 largest bank holding companies enjoyed significantly lower borrowing costs than smaller banks. He calculated the taxpayer-funded subsidy at $34.1 billion a year.
Bailing Out a Welfare State: The California-Greece Debate
by Bill Bonner
Trichet to Greece: Drop Dead!
Obama to California: Uh…
Yesterday, stocks lost 103 points on the Dow. This looked like a confirmation to us. The stock market appears to have begun its next and final phase…
AP seemed to think so too:
“Stock investors see threats from all directions,” said the headline.
We didn’t bother to read the article. We already know the directions.
From the north, investors worry about falling consumer demand. Consumers are in a funk – they have more debt, less income, fewer jobs, and less access to credit. The only news on that front we have today is that even jumbo housing loans are going bad…delinquencies are up to 9.6%.
From the east, investors worry about the continued invasion of cheap consumer goods and cheap services. China’s economy is said to be growing at double-digit rates. How can US firms compete? And what if China is a bubble, as Jim Chanos believes? When it blows up, US stocks will come down too.
From the south comes the threat of higher interest rates. The poor dopes think the recovery might be for real. If so, inflation will rise and the feds will increase interest rates…possibly cutting off the new boom.
And from the west what do they have to fear? Well, there’s that business in Europe. You know, Greece and all. The PIIGS – Portugal, Italy, Ireland, Greece and Spain… Europe’s peripheral countries are in trouble. Lenders fret that they might be forced to default on their debt. So, they want higher interest rates. This, of course, just makes state finances worse…pushing the PIIGS closer to default.
The PIIGS owe $2 trillion, which might need to be restructured. Yes, dear reader, the sovereign debt problem is a big one – much bigger than Bear Stearns, Lehman Bros. and AIG. But the biggest porker of all – the USA – has fives times as much sovereign debt as all the PIIGS put together.
It won’t take investors long to figure out that there isn’t a whole lot of difference between Greece’s finances and those of the US. Each has about the same amount of debt and the same size deficit, relative to GDP. The big difference is that the US ultimately controls the currency in which its debt is calibrated. Greece does not. Neither does California.
Both California and Greece borrow long-term at about the same rate…around 6%. Lenders know that when their backs are to the wall, both governments will have only two choices, not three. They can cut spending. Or, they can default. What they can’t do is wiggle out of their obligations by inflating their currencies.
Jean Claude Trichet has already made that clear:
“…belonging to the euro area, you…have an easy means of financing your current account deficit. You share a currency that is credible, so that you have a quality of financing that corresponds to that of a credible currency.”
He went on to say that Greece contributes only about 3% to the total output of the euro-zone. If push comes to shove, Greece will be pushed out rather than allowed to weaken the euro.
Then, Mr. Trichet made an odious comparison. California is a much bigger part of the US economy than Greece is of the euro economy. In fact, it is more than four times as large. Will the US come to California’s aid? Mr. Trichet didn’t say.
It is possible, of course, that Mr. Obama will say to the Golden State what Gerald Ford said to the Big Apple. In 1975, New York City’s back was to the wall. It appealed to Washington for help. “Ford to City: Drop Dead,” was the famous headline in the New York Daily News, reporting the president’s response.
New Yorkers were incensed. Later, they realized that by vowing to veto a bailout President Ford had done them a great favor; he forced New York to clean up its act. The city went on to its greatest years. Likewise, the feds would be doing all of us a favor by letting failure fail with dignity.
Will Obama help California mend its ways? Or will he turn it into a zombie state?
Prechter Predicts 'Nowhere Will Be Safe'
Robert Prechter, the president of Elliott Wave International and perhaps the world’s best-known technical analyst, was in typically downbeat mood at a meeting in London late Monday. On stocks, he said:We’re in a bear market and it’s going to be a big one… a very large bear market.
Prechter told the Society of Technical Analysts that individuals, advisers and institutions are all way too bullish on stocks. He also forecast falls in gold and oil prices, suggesting we’re about to see a very severe bout of deflation as the markets head south and the value of money starts to go up. Moreover, Prechter reckoned that corporations still have too much debt. There was a partial recovery in 2009 but credit will crunch again, he said. Technically, it’s a “grand supercycle top”, Prechter reckons. And it’s a world-wide phenomenon that will affect every market everywhere. Nowhere will be safe. You have been warned.
Faber Says U.S. Would Be Rated Junk If It Were a Company
by Tyler Durden
Marc Faber discusses America's unsustainable debt load in this interview with Margaret Brennan on Bloomberg TV. An amusing observation: the GDP growth from each $1 of new total debt has dropped from $0.25 to -$0.60. Also some much deserved Bernanke and Krugman bashing. Why it is so difficult to realize that the only way out of the crisis is to cut corporate and sovereign debt, we don't understand. Ah yes, because for that to happen, equity values across virtually all of the US economy would be wiped out... And that would destroy the myth that there is any real equity value in America.
How to invest for a global-debt-bomb explosion
by Paul B. Farrell
Wake up investors. Are you prepared for the economic anarchy coming after a global-debt time bomb explodes? Are you thinking outside the box? Investing differently? Act now -- tomorrow will be too late. Start by looking past the endless cable skirmishes between Rush, Glenn, Bill and Shawn versus Harry, Nancy, Ben and Barack. Look way past the insurgency bonding Sarah and her diehard Tea Party revolutionaries with Ron Paul's Neo-Reaganite ideologues, Fat-Cat Bankers and the Party of No, all planning a massive frontal assault on the 2010 elections, hell-bent on destroying the presidency. All that's the sideshow.
The Big One is coming soon, bigger than the 2000 dot-com crash and the 2008 subprime credit meltdown combined. A huge market blowout. And as Bloomberg-BusinessWeek predicts: "The results won't be pretty for investors or elected officials." After the global-debt bomb explodes don't expect a typical bear correction followed by a new bull. Wall Street's toxic pseudo-capitalism is imploding. Be prepared for a massive meltdown. Yes, already the third major bubble-bust of the 21st century, triggered once again by Wall Street's out-of-control Fat Cat Bankers. And it's dead ahead.
Can your family survive in the anarchy after the debt bomb explodes?
America's already descending into economic anarchy. We're all trapped in a historic economic supercycle, a turning point that must bleed through a no-man's land of lawless self-destructive anarchy before a neo-capitalistic world can re-emerge. Investors tell me they "feel" it at a deep level, "know" it's happening. They keep asking: "What's the best investment strategy to prepare now?" This is no joke, folks. Are you prepared? Or preparing? Will your family survive in a post-apocalyptic world, when anarchy is rampant in America? Look at Washington, Wall Street and Corporate America today. You know it's already begun.
You are witnessing a fundamental breakdown of the American dream, a systemic breakdown of our democracy and our capitalism, a breakdown driven by the blind insatiable greed of Wall Street: Dysfunctional government, insane markets, economy on the brink. Multiply that many times over and see a world in total disarray. Ignore it now, tomorrow will be too late.
Not a war about ideology, but an economic game-changer
This is a war to control 299 million American taxpayers. A war waged by the "Happy Conspiracy" Jack Bogle profiled in his 2004 "Battle for the Soul of Capitalism," a war machine of Fat Cat Bankers, CEOs, 42,000 mercenary lobbyists and a Congress held hostage to unlimited campaign donations. Their conspiracy has been waging this war against Americans for decades, long before the Supreme Court exposed their dirty secret. Yes, your enemy is that "Happy Conspiracy:" It has degraded into a pseudo-capitalism with no conscience, no sense of the public good, hell-bent on controlling America's mind, your money and the global markets for its own selfish ends. And eventually it will trigger the game-changing global-debt bomb, the third global meltdown of the century that finally ignites the Great Depression II, plunging us into an era of anarchy.
Investors keep asking: "If it is coming, how do I invest? Buy gold? Commodities? Hedge? Short trading? TIPS? Hoard cash? Buy and hold? Lazy Portfolios?" What if the Dow sinks below 5,000? Maybe the worst-case scenario recently predicted by Bob Prechter: A deeper plunge to the 1,000 range? Imagine a global depression, a bear market dragging on for decades: "How do I protect my family? Can I ever retire? What do I invest in? How can anyone prepare?"
How America's two classes are preparing for a descent into anarchy
As America descends into anarchy your family's survival and your ability to retire will depend on which of America's two economic classes you belong to out of our total of roughly 300 million citizens:
- "Average Joe & Jane" Americans: You're one of 299 million Main Street Americans. Average income is $50,000, only 10% of the average bonuses paid to Wall Street's Fat-Cat Bankers. Or you're already one of America's 20% underemployed ... maybe on food stamps ... maybe among the 47 million with no medical insurance ... your retirement assets are about $50,000, a year's survival. And you are "mad-as-hell" you're not working "inside" the "Happy Conspiracy."
- "Happy Conspiracy" Insiders: You're one of the lucky million or so elite Insiders in the "Happy Conspiracy." You may work for a Fat-Cat Bank that American taxpayers bailed out last year so you pocketed a 2009 bonus gift of somewhere between $600,000 and $10 million. Maybe you're a Corporate American CEO. Maybe you're on the Forbes 400 list. Or you're a U.S. Senator.
Here's how these savvy Insiders are preparing: In his 2008 best-seller, "Wealth, War and Wisdom," hedge fund manager Barton Biggs, a highly respected Insider in the "Happy Conspiracy," advised rich insiders to expect the "possibility of a breakdown of the civilized infrastructure." His advice: Make tons of money. Buy an isolated farm in the mountains. Protect family against the barbarians: "Your safe haven must be self-sufficient and capable of growing some kind of food ... It should be well-stocked with seed, fertilizer, canned food, wine, medicine, clothes, etc. Think Swiss Family Robinson."
How Wall Street insiders will treat Main Street in 'The Anarchy'
And when the barbarians do come, firing "a few rounds over the approaching brigands' heads would probably be a compelling persuader that there are easier farms to pillage." Imagine a scene like Port-au-Prince after the quake. Biggs is no radical anarchist, he's an establishment Insider, a great guy. We both arrived at Morgan Stanley about the same time. Biggs remained 30 years, was Morgan's chief global strategist. Ten times Institutional Investor magazine put him on Wall Street's "All-America Research Team."
True, he did hedge his prediction of the coming anarchy. His odds: 1 in 10. But in an early 2009 Newsweek article, "A Generation of Destruction: Throwing money at the problem and propping up greedy banks is like trying to put out a fire by pouring gasoline on it," Biggs teased us with a bleak scenario: "Great cycles of wealth creation have usually lasted about two generations, or 60 years. Inevitably, unequal riches corrupt and create envy, and they are always followed by a generation of enormous wealth destruction."
Warning: By vastly understating the risks while his Insiders prepare for the coming anarchy, Biggs is quietly misleading and disarming the rest of America. The truth is Insiders in the "Happy Conspiracy" elite will follow Biggs' ultra-simple investment strategy: Make massive amounts of money fast using short-term strategies, spout lip service about the "public good." But always act in your own self-interests first, preparing for when anarchy spreads worldwide in an economic pandemic.
How can America's 299 million 'second-class citizens' invest for anarchy?
So what can the average Joe and Jane, the other 299 million Americans do? Warning: In anarchy, nobody knows. Period. The only possible strategy: "Think Swiss Family Robinson." Stockpile like a "Happy Conspiracy Insider." Many still challenge us about proven strategies like buy and hold, Modern Portfolio Theory, Lazy Portfolios. Unfortunately, they all need a real democracy driven by honest, transparent capitalism to function effectively. They can't function in anarchy. And Wall Street's already lapsed into a toxic pseudo-capitalism, using it to manipulate Main Street America. Eventually that mindset will force Main Street Americans to misuse the same dark "Swiss Family Robinson" tactics as the Insiders in order to survive the coming anarchy.
What's our alternative? A new American Revolution
But wait, wait, I hear you asking loudly: There must be an alternative to this dark descent into anarchy, to the loss of everything that made America the greatest nation in history? Yes there is an alternative. Out of the ashes of anarchy must come a Second American Revolution. But unfortunately nothing will happen until a great crisis awakens America ... shocks the conscience of the masses ... we are "asleep" ... only a seismic, systemic shock will trigger the necessary revolution.
The future of our economy and indeed our nation demands another political revolution. We must take back our democracy and capitalism from a government run by Wall Street and its "Happy Conspiracy" ... their toxic self-serving power hold must be broken and, if not, a rising new conspiracy of China, India, oil-sovereignties and asset-rich nations will replace our homegrown "Happy Conspiracy" as it eventually goes down in the flames of anarchy. Sadly, that's the future many of us realists see ahead for America.
Wall Street's Race to the Bottom
by Elizabeth Warren
Jamie Dimon is wrong. We shouldn't expect a crisis 'every five to seven years.'
Banking is based on trust. The banks get our paychecks and hold our savings; they know where we spend our money and they keep it private. If we don't trust them, the whole system breaks down. Yet for years, Wall Street CEOs have thrown away customer trust like so much worthless trash. Banks and brokers have sold deceptive mortgages for more than a decade. Financial wizards made billions by packaging and repackaging those loans into securities. And federal regulators played the role of lookout at a bank robbery, holding back anyone who tried to stop the massive looting from middle-class families. When they weren't selling deceptive mortgages, Wall Street invented new credit card tricks and clever overdraft fees.
In October 2008, when all the risks accumulated and the economy went into a tailspin, Wall Street CEOs squandered what little trust was left when they accepted taxpayer bailouts. As the economy stabilized and it seemed like we would change the rules that got us into this crisis—including the rules that let big banks trick their customers for so many years—it looked like things might come out all right. Now, a year later, President Obama's proposals for reform are bottled up in the Senate. The same Wall Street CEOs who brought the economy to its knees have spent more than a year and hundreds of millions of dollars furiously lobbying Washington to kill the president's proposal for a Consumer Financial Protection Agency (CFPA).
Within the thousands of pages of print in the "Restoring American Financial Stability Act" now before the Senate, the consumer agency is the only proposal that would help families directly. Even those most concerned about the role of personal responsibility concede that it is hard for families to make smart decisions and to compare products when the paperwork on mortgages, credit cards and even checking accounts has morphed into reams of incomprehensible legalese. The consumer agency is a watchdog that would root out gimmicks and traps and slim down paperwork, giving families a fighting chance to hang on to some of their money. So far, Wall Street CEOs seem determined to stop any kind of watchdog. They seem to think that they can run their businesses forever without our trust. This is a bad calculation.
It's a bad calculation because shareholders suffer enormously from the long-term cost of the boom-and- bust cycles that accompany a poorly regulated market. J.P. Morgan CEO Jamie Dimon recently explained this brave new world, saying that crises should be expected "every five to seven years." He is wrong. New laws that came out of the Great Depression ended 150 years of boom-and-bust cycles and gave us 50 years with virtually no financial meltdowns. The stability ended as we dismantled those laws and failed to replace them with new laws that reflected modern business practices.
The reputations of Wall Street's most storied institutions are evaporating as the lack of meaningful consumer rules has set off a race to the bottom to develop new ways to trick customers. Wall Street executives explain privately that they cannot get rid of fine print, deceptive pricing, and buried tricks unilaterally without losing market share. Citigroup learned this the hard way in 2007, when it decided to clean up its credit card just a little bit by eliminating universal default—the trick that allowed it to raise rates retroactively, even for consumers that did nothing wrong. Citi's reform resulted in lower revenues and no new customers, triggering an embarrassing public reversal. Citi explained sheepishly that credit cards were now so complicated that customers couldn't tell when a company offered something a little better. So Citi went back to something a little worse. Without a watchdog in place, the big banks just keep slinging out uglier and uglier products.
With their reputations in tatters, the CEOs have decided to go on the offensive in Washington. They might have had some thoughtful suggestions for how to better shape a consumer agency. Instead, they have unleashed lobbyists who are determined to do anything to kill the consumer agency. The latest lie is that the CFPA is "big government." The CEOs all know that the current regulatory structure, which they support, is big government at its worst: bureaucratic, unaccountable and ineffective. The CFPA will consolidate seven separate bureaucracies, cut down on paperwork, and promote understandable consumer products. In the process, it will stabilize the industry, rebuild confidence in the securitization market, and leave more money in the pockets of families. Complaining about short, readable contracts and efforts to slim down bureaucracy only further diminishes the banks' credibility.
This generation of Wall Street CEOs could be the ones to forfeit America's trust. When the history of the Great Recession is written, they can be singled out as the bonus babies who were so short-sighted that they put the economy at risk and contributed to the destruction of their own companies. Or they can acknowledge how Americans' trust has been lost and take the first steps to earn it back.
Ms. Warren is a law professor at Harvard and is currently the chair of the TARP Congressional Oversight Panel.
Hitting Goldman Where It Hurts
President Obama has taken aim at the world's largest private-equity operation: Goldman Sachs Group Inc. Most of the focus surrounding the White House's bank-reform push has been its proposed ban on banks' proprietary-trading activities. But the administration also wants to prohibit banks from making private-equity investments, in which they use their capital to acquire stakes in companies, often using large sums of borrowed money. The proposal, debated on Capitol Hill last week, is short on detail. But should it become law, it could have by far the biggest impact on Goldman, whose private-equity holdings include business-jet maker Hawker Beechcraft Corp., hotel chain Hyatt Hotels Corp. and Texas utility giant Energy Future Holdings Inc.
The firm's private-equity exposure exceeds that of the world's largest buyout firms. Goldman has roughly $14 billion of corporate and real-estate private-equity holdings on its balance sheet, with more than three-quarters of that amount in illiquid, hard-to-sell assets, according to securities filings. By comparison, Blackstone Group and Kohlberg Kravis Roberts & Co. have $1.35 billion and $4.1 billion in private-equity investments on their balance sheets, respectively. Goldman has raised more than $90 billion in the past 10 years across its private-equity funds and currently has roughly $35 billion in uninvested capital, according to Preqin, a London-based data provider. Those numbers also exceed those of the biggest buyout shops. Carlyle Group currently has $87.9 billion under management, with $30 billion of "dry powder."
Started in 1992 and overseen by Richard Friedman, the buyout business has broadened beyond its corporate and real-estate funds. The firm is investing a $13 billion fund that mostly invests in "mezzanine" debt that fills the gap between a borrower's equity and senior debt, as well as a $10 billion loan fund that invests in the senior part of companies' capital structures. Most of the money in Goldman's private-equity vehicles comes from outside investors—pension plans, sovereign-wealth funds and wealthy families—who pay Goldman's asset-management unit rich fees to manage their money. But the firm and its employees account for a substantial percentage of those assets. Roughly $9 billion of Goldman's flagship $20.3 billion private-equity fund—Goldman Sachs Capital Partners VI, the second-largest buyout fund ever raised—comes from Goldman's balance sheet and its employees.
Under Mr. Obama's proposal, banks would likely be free to manage customer money earmarked for private-equity funds. But Goldman would have to divest its own holdings, a complicated task. One alternative would be to spin out its private-equity arm, according to people familiar with the firm. Goldman could also give up its bank-holding-company license to avoid spinning out the private-equity business, these people said. The firm's $14 billion in private-equity holdings still represent less than 2% of the $849 billion in assets on its balance sheet as of the end of 2009. Nevertheless, the fear is that these types of illiquid, hard-to-sell investments don't belong on banks' books.
Goldman's private-equity holdings across its corporate and real-estate investments have seesawed in recent years. In 2009, it recorded a loss of $410 million; in 2008, losses of $3.48 billion; in 2007, it booked gains of $3.3 billion. Such volatility has led other banks to jettison their private-equity arms or reduce them. J.P. Morgan Chase & Co.'s Chief Executive Officer James Dimon spun off the bank's flagship private-equity arm, J.P. Morgan Partners, four years ago, citing concerns about the unit's size and unpredictable results. It has retained a smaller buyout business, One Equity Partners. Years ago, Morgan Stanley also exited large private-equity deals and now focuses on smaller transactions.
But neither J.P. Morgan nor Morgan Stanley was most concerned about balance-sheet risk when they divested. They were instead worried about criticism from banking clients that the bank took the best deals for itself. That criticism continues to dog Goldman, especially from other private-equity firms that are its clients. A Goldman spokeswoman declined comment for this article, but in an earnings call last month Chief Financial Officer David Viniar defended the investing activities. "Our private-equity business is an important business for Goldman Sachs," Mr. Viniar said. It "works," he added, noting that "a lot of our very important clients" are invested in it, and that "we invest alongside" them.
More than any other bank, Goldman has integrated its own private-equity work into its day-to-day business. Companies in Goldman's private-equity portfolio often become clients of Goldman's other businesses, such as mergers-and-acquisitions and underwriting initial public offerings. For instance, Goldman has earned more than $100 million in fees from Energy Future Holdings, according to people familiar with the company. Critics of the proposed Obama legislation said the White House is overreaching. "Ten years ago, the government decided it was OK for bank-holding companies that were well managed and well capitalized to have passive merchant banking," said Doug Landy, a banking partner at the law firm Allen & Overy LLP. "I haven't seen any evidence that there have been such poor investments."
He's Come A Long Way: Summers Attacks 'Bloated Financial System'
Showing just how far his previous economic ideology has fallen from grace, White House senior economics adviser Larry Summers went on to CNBC Tuesday morning and sounded off against a "bloated financial system" while offering a ringing endorsement for the president's effort to regulate Wall Street. Once a cheerleader for Wall Street immoderacy, Summers decried a "system that is based on massive borrowing, intermediated through a bloated financial system, in order to support excessive consumption."
Presented with Wall Street's longtime goals of slashing Medicare and Social Security, Summers refused to swoop down for the deficit hawk bait thrown out by CNBC co-anchor Erin Burnett:"In the longer term, are you willing to stand up and say, 'Hey, America, your pensions are going to be smaller, your Medicare benefits are going to be lower, your Social Security retirement age is going to go way up and your benefits are going to go lower even if you paid in?'" Burnett asked. "Are we at the point where the government has to say, 'These are painful facts, and we might lose re-election by telling you, but we're going to telling you the truth?'" "Erin," replied Summers, "listening to you, it sounds like it's an exercise in sadism, who can cause the most pain."
Summers, in sparring with the CNBC hosts, repeatedly called for tough regulation. "The president has been emphatic on what have been the excesses of the financial sector: irresponsibility, innovation that served no real purpose, except the exploitation of customers. And that is why the president has pushed so hard for strength in financial regulation," said Summers. As Treasury Secretary under Clinton, Summers advocated for the passage of the Gramm-Leach-Bliley Act, which in 1999 repealed key portions of the Glass-Steagall Act and helped create the bloated system propped up by massive borrowing that he decries today.
When the question of regulating derivatives contracts came up in the late '90s, Summers asserted that his faith in the sophistication of the market participants made such rules unnecessary. Summers has since learned that it was that very sophistication that created the problems, rather than prevented them, as banks and traders used their asymmetrical access to market knowledge and information to game the system - what Summers now calls "innovation that served no real purpose, except the exploitation of customers."
His arguments at the time show just how far the ground has shifted. "The parties to these kinds of contracts are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies," Summers told Congress in the late '90s. "To date there has been no clear evidence of a need for additional regulation of the institutional OTC derivatives market, and we would submit that proponents of such regulation must bear the burden of demonstrating that need." Summers was wrong. It would be Wall Street itself, rather than proponents of reform, that would end up demonstrating that need. Whether Congress acts on that demonstration remains to be seen.
The Coming Showdown With The Unions
At the center of the current fiscal troubles in Greece, Spain, Portugal and elsewhere in Europe are the promises made by governments to fund union salary increases and pension plans. Unions in Europe are much stronger than they are in North America, and in many of Europe’s less-wealthy countries, governments have chosen over the years to appease union demands even though it meant driving fiscal deficits well beyond the level tolerated by EU rules. Now that these governments are finding it impossible to continue to borrow on global markets without firm evidence that these deficits are going to be brought down, proposals to cut union pay or benefits are being met with strikes by firefighters, police, teachers, farmers, and others.
Do not for a moment think that these problems are not to be found in the United States. The difference here is that the “appeasement”, such as it is, has been concentrated at the state and local level, though the federal government has its share of unfunded promises to workers. The 50 states last year ran up a combined deficit of around $180 billion – coincidentally about the same amount that the US has spent bailing out AIG. The federal government has also helped out the states during this fiscal crisis, by lending them money to continue paying normal as well as emergency employment benefits to laid off citizens. This has averted a real crisis, since states are constitutionally required to plug any annual deficits. The real problems will show up later this year and next when the federal loans run out.
The basic cause of these fiscal problems in the states has not been any sudden explosion of spending, but rather an implosion of revenue. Tax receipts across the nation are down due to the economic downturn. States which rely on property taxes and income taxes have been especially badly hurt, but sales tax revenues have also suffered as consumers cut back on their spending. Municipal tax receipts in most communities are lower, especially for cities and towns which took in a bonanza from property transfer taxes during the housing bubble. Even the federal government has seen a dramatic and unprecedented drop in tax revenues, especially in the area of capital gains taxes. The federal government, unlike other governments, can run deficits and certainly has chosen this route rather than seek out savings from spending cuts.
At least when it comes to state and local deficits, the US is now at the stage where government officials must look at spending cuts, and their only real choice if they want to make a serious dent in these deficits is to focus on union workers, their salaries, their overtime, their work hours, and their pension payments. Unions have been banished from many parts of the private economy, and are to be found only in a few manufacturing sectors like automobiles where they have had a traditional stronghold. But unions remain very strong and well represented in the public sector, as teachers, police, firefighters, mass transit workers, and civil engineers.
There are at least two ways to look at union contributions to the public sector. From the union perspective, workers in state and local government have decent middle class salaries because of the unions. An hourly wage may be in the $25/hr. range for typical employees; managers on salaries can earn $100,000 or more in many large to medium size communities, based on salary scales that are public and mandated by the state or local government. In expensive communities throughout California, for example, without the unions there would be no government employees, because middle class workers cannot afford to live in towns where the average home costs $500,000. Additionally, union members get generous pension benefits, on the theory that they have foregone years of wealth-creating bonuses that would have been theirs if they worked in the private sector. There are, obviously, no stock option plans for government workers.
The other way to analyze unions is from the outside looking in, and here the opportunity for outrage is certainly high. In medium to large cities, the pay scales for managers often dictate a salary of $250,000 or more. Retirement for most workers starts at age 50, with a pension being paid out anywhere from 70% - 90% of income at the time of retirement. These pensions are lifetime guaranties, and they are supplemented by generous health care benefits not typically found in the private sector. Many communities allow “double-dipping” during the last five years of employment until retirement, wherein the worker can take home full pay, full retirement benefits, and full pension payments.
These policies lend themselves to anecdotal horror stories that do not sit well with the average taxpayer in the private sector who has seen their wages stagnate, their benefits cut, their working years extended beyond age 65, and their 401k’s wiped out. Stories appear frequently in the press about the ticket taker at the subway station who is earning $85,000 a year, or the recent case of the Under Sheriff of San Luis Obispo county in California, who has taken home $640,000 a year because of double-dipping allowances (his assistant takes home $340,000 under the same plan).
City managers everywhere are looking to reduce salary scales for government workers, cut back on benefits such as the matching contribution government makes to pension plans, and redefine the government’s authority to reduce staffing (in many cases it is very difficult to downsize union staff). On top of this, these managers are being informed that the union pension plan is now seriously underfunded thanks to massive losses in the stock market, and that the state or local government is legally obligated to make up the difference. In many situations these deficiencies total in the billions of dollars – money that local or state government doesn’t have.
You thus have the making of a classic political and economic battle. Unions are showing up in force at council meetings or state legislatures to protest cutbacks. Teacher strikes are becoming more common, and police and firefighters who cannot strike can at least protest and issue dire warnings of fire fatalities and jumps in crime if services are reduced. On the other side, right wing radio commentators have plenty of anecdotal fodder to deride union featherbedding and egregious benefit packages, and it doesn’t take much to stir up the general electorate against appeasing the unions when so many private sector workers can only dream of guaranteed pensions and health benefits for life. In fact, where the general public often finds itself in these battles is voting down any initiatives to raise taxes in order to meet legal obligations to the unions, the result being that the state has to renege on these obligations in order to balance the budget.
Many states and localities can still try appeasement to avoid nasty run-ins with the unions. Phoenix, Arizona chose to increase tax on food by 2% rather than fire public workers or reduce their pay and benefits. Ironically, this tax falls most heavily on the poor, many of whom work for local or state government in menial but stable positions. When it comes to funding the pension plan deficits, one easy accounting gimmick is to change the long term earnings assumptions of the plan. In many cases these plans already have ridiculous assumptions as to asset growth, often using for the stock portion of the plan an assumption that equities will earn 8% p.a. over time. It takes just a stroke of the pen to declare this assumption to be 10% p.a., so that the plan will magically take care of any deficits by itself with superior performance. Another trick is to authorize plan managers to invest in hitherto forbidden financial instruments like derivatives or commodities, on the belief that the returns are greater in these sectors. They are certainly greater, but so is the risk, and inevitably these desperate attempts to reach for risk are bound to fail.
It is not too difficult to determine the outcome of this fight. States and localities have no choice but to close their deficits, and the taxpayer has no appetite for greater taxes. Therefore the unions will have to accept cutbacks in salaries, wages and benefits; reductions in pension plans (amounting to an outright repudiation of legally-agreed payouts); and the loss of job protection, so that government officials can fire workers much more quickly. There will be nasty strikes over the next few years, and lawsuits aplenty as these cutbacks are enforced, but there simply isn’t the money to continue to pay union workers in government anything like what they have received in the past.
The deflation that has ravaged the pay and benefits of the middle class private sector worker is about to work its damage on the public sector as well. The middle class in the US will shrink even more, as one of the last bastions of protection against rampaging globalization and Republican market orthodoxy succumbs. We can say “one of the last bastions”, but there is still one left, a sector of the economy that isn’t even unionized. That is the pay and benefit programs for the military, especially the officer corps who can retire at 50, slip into a well-paying job in the industrial complex, yet also take home generous retirement benefits. The costs of supporting tens of thousands of these retirees is galloping forward year after year, but this is so far a sacrosanct area that no politician will touch. Even the Department of Defense may not be able to hold out forever, if economic conditions get really bad (and that is likely to be the case). If so, the concept of retirement with a fixed pension payment will be obliterated in this country, as the US continues on its path of erecting third world standards of pay and benefits for all its workers.
Greek unions launch first assault on austerity plan
A civil servants' strike grounded flights and shut down public services across Greece on Wednesday, as labor unions mounted their first major challenge to austerity measures in the debt-plagued country. Air traffic controllers, customs and tax officials, hospital doctors and schoolteachers walked off the job for 24 hours to protest sweeping government spending cuts that will freeze salaries and new hiring, cut bonuses and stipends and increase the average retirement age by two years.
"Today, the workers give their reply," loudspeakers blared in the capital's central Syntagma Square, where hundreds of pensioners and striking workers began gathering ahead of demonstrations planned later in the morning. The strike has left state hospitals working with emergency staff only, while national rail travel was also disrupted, although urban mass transport was unaffected. "It's a war against workers and we will answer with war, with constant struggles until this policy is overturned," said Christos Katsiotis, a representative of a communist-party affliated labor union.
Greece has come under intense pressure from its European Union partners to slash spending after it revealed a massive and previously undeclared budget shortfall last year that continues to rattle financial markets and the euro, the currency shared by 16 EU members. Prime Minister George Papandreou, who was in Paris Wednesday to discuss the economic crisis with French President Nicolas Sarkozy, has repeatedly said the country will sink under its debt unless everyone contributes to a solution. But labor unions are unconvinced, and on Wednesday they ended weeks of caution after Papandreou's new Socialist government deepened cuts, slashing early retirement rights and even tapping the country's powerful Orthodox Church for more taxes.
"It wasn't the workers who took all the money, it was the plutocracy. It's them who should give it back," said Alexandros Potamitis, a 57-year-old retired merchant seaman. The government has insisted that those on low incomes will be protected and will even enjoy lower taxes, with the austerity plan targeting the better off. Finance Minister George Papaconstantinou announced another round of austerity measures Tuesday night, just before Wednesday's strike: adding euro0.14 ($0.19) in taxes to the price of a liter of regular unleaded gasoline, and announcing plans to oblige all Greek businesses — including gas stations, cab drivers and vendors at farmers' markets — to issue receipts.
Resistance is mounting nonetheless. The umbrella civil servants' union that called Wednesday's 24-hour strike, ADEDY, has said it will decide later this week on further strike action. Greece's largest labor organization, the umbrella GSEE union, has called a separate one-day strike on Feb. 24. "I don't care about the (country's) problems. I didn't steal a single euro, why should I pay?" said Christos, an elderly man who said he retired after working for 47 years and was now barely surviving on a pension of euro640 ($880) a month. He refused to give his surname, saying he was afraid he would lose his pension if he complained openly. It remains unclear whether the protests will represent the start of a serious labor backlash against the urgent reforms or a demonstration of union dissatisfaction in a country where strikes are common.
Papandreou's Socialists came to power in early elections last October, drumming the Conservative party in the polls, and they now enjoy a strong majority of 160 seats in the 300-member Parliament, compared to the main opposition's 91. Papandreou has already faced down a protest by farmers, who demanded higher subsidy payments and staged tractor blockades on Greek highways for nearly three weeks, ending Tuesday. Markets have also reacted positively on indications that wealthy European countries are closer to rescuing Greece. Stocks in Europe and the United States rose Tuesday on expectations of some kind of decisive action to prevent a Greek debt default that could spread to other countries, undermining Europe's hesitant economic recovery.
European Union leaders are to discuss the issue during a summit in Brussels Thursday, and officials have said they will issue a statement on Greece. Markets have reacted well to news that European Central Bank President Jean-Claude Trichet would make a rare appearance at the summit in Brussels — which they saw as confirmation that some kind of help would be discussed. The Athens Stock Exchange opened up Wednesday, with the general price index up 3.23 percent in midmorning trading, a day after closing up 4.96 percent. The spread between 10-year Greek government bonds and the benchmark German issues of equivalent maturity continued to fall, suggesting fears of a default receded. The spread stood at 272.2 basis points, down from about 320 basis points late Tuesday.
Germany backs Greek bail-out as EU creates 'economic government'
by Ambrose Evans-Pritchard
Germany is preparing to drop its vehement opposition to a rescue package for Greece, fearing that a rapid escalation of the debt crisis in Southern Europe could endanger German banks and damage the euro. Wolfgang Schäuble, Germany's finance minister, has asked officials to prepare a plan in time for a summit of EU leaders on Thursday, according to reports in the German media. The options include either a loan from EU states or some sort of institutional EU response. The news pushed the euro to $1.38 against the dollar, the strongest one-day rally since the single currency began its nose-dive late last year. Yields on Greek 10-year bonds plummeted 36 basis points to 6.39pc in a matter of hours as speculators scrambled to exit overstretched positions, with synchronised moves for Portuguese, Spanish, and Italian bonds.
Michael Meister, parliamentary chief for Germany's Christian Democrats, said the crisis could not be allowed to drag on. "Our top priority is the stability of the euro," he told FT Deutschland. "Should Greece receive help, it will only be under tough conditions and if the Greek government undertakes root-and-branch reforms." Germany's apparent backing for a bail-out comes despite worries that it will lead to the breakdown of fiscal discipline across the Club Med region. It also raises troubling questions of fairness. Ireland has tackled its own crisis by slashing wages and going far beyond any measure so far offered by Greece, yet Dublin has not received help.
Germany's dramatic shift in policy changes the character of the euro project. It follows weeks of soul-searching in Berlin, and after increasingly loud pleas from Brussels, Paris and southern capitals. The deciding factor was concern that letting Greece fail risked a "Lehman-style" run on Club Med debt, with systemic spill-over across Europe. German exposure to the region amounts to €43bn in Greece, €47bn in Portugal, €193bn in Ireland, and €240bn in Spain, according to the Bank for International Settlements. German lenders are already vulnerable, with the world's lowest risk-adjusted capital ratios bar Japan.
The breakthrough comes as this week's summit of EU leaders in Brussels rapidly evolves from a policy workshop into an historic gathering that may catapult the EU across the Rubicon towards fiscal federalism and a de facto debt union. The EU's top brass are seizing on the crisis to push for a radical extension of EU powers, saying Greece has exposed the deep flaws in the structure of monetary union. Herman Van Rompuy, the EU's new president, has submitted a text calling for the creation of an "economic government" that shifts responsibility for economic planning from national authorities to the "EU level".
In a parallel move, Commission chief Jose Barroso said Brussels has treaty powers allowing it to take the reins of economic management. " This is a time for boldness. I believe that our economic and social situation demands a radical shift from the status quo. And the new Lisbon Treaty allows this," he said. "Economic policy isn't a national, but a European matter. No modern economy is an island. When a member state doesn't make reforms, others suffer because of that." Rumours swept the markets all day on news that Jean-Claude Trichet, the head of the European Central Bank, had cut short a trip to Australia to attend the summit.
It is unclear how long Tuesday's reprieve will last, or whether any bail-out involving loans – as opposed to subsidy – can solve the deeper crisis of Club Med competitiveness. Wealthy Greek citizens have shifted €7bn from banks in Greece to foreign accounts, fearing that capital controls in Athens. The withdrawals have echoes of the Mexico's Tequila Crisis in 1994 when Mexicans set off a spiral by shifting funds to the US. The risk is that capital flight will erode the deposit base of Greek banks, forcing them to shrink loan books. Greek banks do not rely on the fickle funding of wholesale markets – the undoing of Northern Rock – but this does not shield them from a deposit run. Goldman Sachs has downgraded the National Bank of Greece and GPSB. "Greece faces both a liquidity and, potentially, a solvency problem. While we believe that, individually, Greek banks tend to be well-run, the problems they face are outside their operational control," it said.
Greek crisis intensifies as Joe Stiglitz calls for Europe to 'teach the speculators a lesson'
Pressure on the Greek government to put its books in order or face a bail-out intensified as investors continued to flee its debt, pushing the country further towards a possible debt spiral. Yields on Greek debt rose by 14 basis points, as investors digested the fact that G7 and eurozone finance ministers refused at their weekend summit to provide more detail on a rescue package for the troubled economy. Alongside Portugal, Spain, Italy and Ireland, Greece has been the focus of widespread market selling over the past few weeks, with investors fearing the countries may be unable to repair their balance sheets alone. The interest rate on Greek 10-year benchmark debt is now 6.75pc, compared with fellow euro member Germany’s rate of 3.14pc.
Suspicions that the Greek crisis could give way to a full-blown attack on the euro have been reinforced as it emerged that currency speculators have increased their bets against the currency to the highest level since its creation. Contracts on the Chicago Mercantile Exchange (CME), a closely-watched speculation barometer, showed that in the past week net short positions against the euro rose from 39,500 contracts to 43,700 – worth €5.5bn ($7.5bn). Greek prime minister George Papandreou has characterised the behaviour of capital markets, which have put a rising premium on interest rates to his government, as part of a broader speculative attack on the currency.
The CME figures will spark fears that, much like George Soros in the early 1990s, hedge funds will lay siege to the single currency. Since Greece, Portugal, Spain and Italy, all of whom are facing similar issues, cannot devalue or inflate their way out of the crisis, economists suspect that they will have to receive assistance from other euro nations to avoid inflicting cuts of unprecedented ferocity on their economies.
Economist Joe Stiglitz, who is advising the Greek government, last night denied that the country would require a bail-out, and urged national authorities to intervene in markets to "teach the speculators a lesson". Likening the situation to the Asian financial crisis, in which even healthy economies were targeted as hedge funds and investors withdrew from the region, he told the Sky's Jeff Randall Live show: "The speculators will always look for the weakest link. What they're doing now is a version of the Hong Kong double play in 1997 /1998. "What Hong Kong did in response was to raise interest rates and intervene in the stock market. They burnt the speculators and Europe needs to do the same thing."
EU President's secret bid for economic power
The new President of the European Council, Herman Van Rompuy, is using the financial crisis sweeping the eurozone to launch an audacious grab for power over national budgets, leaked documents reveal. The Independent has seen a secret annexe to the letter being sent by Mr Van Rompuy to European Union heads of government inviting them to the summit to be held tomorrow in Brussels.
In an early and muscular assertion of authority over national governments and over the EU Commission, the Van Rompuy note states: "Members of the European Council are responsible for the economic strategy in their government. They should do the same at EU level. Whether it is called co-ordination of policies or economic government, only the European Council is capable of delivering and sustaining a common European strategy for more growth and more jobs." Mr Van Rompuy states that "the crisis has revealed our weaknesses", adding: "Budgetary plans, structural reform programmes and climate change reporting should be presented simultaneously to the Commission [his italics]. This will provide a comprehensive overview."
An EU source explained: "It has become clear to everyone that this economic crisis can't be solved by individual member states, such as Germany helping out Greece. What we need is the same kind of mechanism that we have now imposed on Greece in order to monitor and survey eurozone countries. So the idea is to put all European economies under surveillance. You can expect some important decisions to be taken this week." In a highly unusual move, the president of the European Central Bank, Jean-Claude Trichet, has broken off from a meeting of central bank governors in Sydney to return to Europe. Pressure on the euro eased, on hopes that the presence of the EU's senior economic policymaker would appease the markets.
Rumours that the French and German governments are ready to bail out Greece have been rife. The Greek Prime Minister George Papandreou will meet French President Nicolas Sarkozy tomorrow. Mr Papandreou's centre-left government has announced a four-year austerity plan to tame its vast budget deficit. However, doubts remain about its chances. In a tragic-comic touch, Greece's tax collectors went on strike last week. Today all flights to and from Greece will be grounded by air-traffic controllers and strikes will also hit hospitals and schools. Although not directly affected, as sterling is outside the eurozone, Gordon Brown will be worried that any weakness in the European economy could endanger the UK's recovery.
The concern being felt in the highest circles of the EU about the "contagion" sweeping through Greece, Spain and Portugal is also clearly displayed in Mr Van Rompuy's confidential note: "The crisis has revealed our weaknesses. Our structural growth rate is too low to create new jobs and to sustain our social systems." Referring to the fact that the EU has no way to resolve a budgetary crisis that affects other members states, Mr Van Rompuy goes on: "Recent developments in the euro area highlight the urgent need to strengthen our economic governance. In our intertwined economies, our reforms must be co-ordinated to maximise their effect."
The European Stability and Growth Pact and the Maastricht Treaty were designed to prevent the sort of fiscal crisis that the eurozone is currently experiencing. Bailouts were ruled out as the treaty made it illegal for any nation to assume the debts of another. The Maastricht rules – limiting member states to an annual budget deficit of 3 per cent a year and an overall national debt to a GDP ratio of 60 per cent – were swept away during the financial crisis. Even during the boom years, nations routinely disregarded them. In the future, Mr Van Rompuy states, "we will focus on the impact of national policies on the rest of the EU with special regard to macroeconomic imbalances and divergences of competitiveness".
The financial crisis comes as the EU's three presidents jockey for position. Mr Van Rompuy is permanent President of the European Council (the job once thought tailor-made for Tony Blair), while the Spanish premier, José Zapatero, is the President of the Council of the European Union and José Manuel Barroso is President of the European Commission. President Barack Obama recently snubbed a proposed spring EU-US summit out of frustration at having to deal with the confusing troika.
The summit will be held away from the usual redoubts of the Euro bureaucracy, in Brussels' Solvay library. "Van Rompuy wanted to create a far more intimate atmosphere without an army of advisers," a source said. "There are a lot of tensions between member states right now, which he is why he decided to get them to talk in an open, friendly setting, starting with aperitifs. The idea is to have a proper brainstorming session and hear everyone's thoughts."
"We are seeing a wholesale selling off of the country"
Greek stocks fell sharply Monday, extending their losing run to four sessions, as investors battered banking shares. The Athens Stock Exchange's general index closed 3.9% lower at 1806.40 on relatively heavy turnover, while major markets firmed. Investors also demanded a higher premium for holding Greek government bonds over German Bunds, the euro zone benchmark. "What we are clearly seeing is not a selloff in just specific Greek shares; we are seeing a wholesale selling off of the country," said Nicholas Douzinas, head of foreign markets at Intersec Securities in Athens. "We are seeing many open sell orders on the market," he added.
At the focus of concerns is the Greek government's attempts to push through emergency austerity plans to reverse widening budget deficits now at four times the European Union limit. With unions planning public protests against government cutbacks on Wednesday, financial markets were speculating that EU leaders would at their Brussels summit devise contingency rescue plans. Banking stocks were especially hard hit, falling 6.8%, amid speculation that Greek banks were facing financing difficulties and possibly further credit-ratings downgrades. Market leader National Bank of Greece dropped 8.5%, while No. 2 lender EFG Eurobank Ergasias dove 9% and Alpha Bank closed 5.4% lower.
But both Greek and foreign banking officials Monday privately denied speculation that the Greek banks were facing any financing difficulties. Analysts said that the selloff in bank stocks reflected the difficult environment facing Greek banks. "I'm a little doubtful about all this speculation," said a senior analyst at a local bank. "But it's a fact, the market sees that the banks are facing a very difficult environment and that's weighing on banking stocks." Indeed, Greek banks, which are due to start reporting results next week with Piraeus Bank SA on Feb. 18, are widely expected to report disappointing fourth-quarter earnings. Since December, when Greece's sovereign debt was hit by three ratings downgrades in quick succession, the Athens stock market has lost more than 1,000 points. The index is down nearly 18% this year.
Bank shares also are suffering from the higher yields that investors are demanding for Greek debt, which indirectly affects their borrowing costs. The yield gap between 10-year Greek and German bonds widened to 3.63 percentage point Monday, up from about 3.50 percentage point on Friday. The cost of insuring government debt against default also rose, reflecting growing concerns that weaker European government borrowers could spill over into the broader 16-country currency union. Spreads on a credit default swap index of developed European sovereigns were set to close at a fresh highs, driven by further weakness in Greek, Portuguese, and Spanish CDS. In late trade, the SovX Western Europe index, which lets investors buy or sell default insurance on a basket of 15 sovereigns, was at 1.125 percentage point, according to index owner Markit, compared with Friday's close of 1.06 percentage points. The index moved above a full percentage point for the first time Thursday.
"The Greece/Portugal/Spain story has taken on the role of the driving force for sentiment towards risky assets," Suki Mann, credit strategist at Société Générale said in a note. CDS are derivatives that function like a default insurance contract for debt. The market's falls came ahead of a meeting Wednesday between Greek Prime Minister George Papandreou and French President Nicholas Sarkozy and a European Union summit on Thursday. Many market participants are looking to see if Greece's EU partners will declare some kind of direct or indirect financial support for the country in an effort to forestall future borrowing problems when the country goes to the bond market in April or May. In addition, the Greek government is to publish a much-awaited tax reform proposal on Wednesday. Civil servants also have scheduled a strike for Wednesday. "Right now, everyone is looking ahead to Wednesday and Thursday," said Intersec Securities' Mr. Douzinas.
The Budget Deficit Crisis Puzzle
by Dean Baker
The country faces a serious crisis in the form of a manufactured crisis over the budget deficit. This is a crisis because concerns over the size of the budget deficit are preventing the government from taking the steps needed to reduce the unemployment rate. This creates the absurd situation where we have millions of people who are unemployed, not because of their own lack of skills or unwillingness to work, but because people like Alan Greenspan and Ben Bernanke mismanaged the economy. The basic story is very simple and one that we have known since Keynes. We need to create demand in the economy. The problem is that, as a society, we are not spending enough to keep the economy running at capacity.
Prior to the collapse of the housing bubble, the economy was driven by booms in both residential and nonresidential construction. It was also driven by a consumption boom that was in turn fueled by the trillions of dollars of ephemeral housing bubble wealth. With the collapse of the bubbles, both residential and nonresidential construction have collapsed. There is a huge amount of excess supply in both markets, which will leave construction badly depressed for years into the future. Together, we have lost well over $500 billion in annual demand from the construction sector. In addition, the loss of the ephemeral wealth created by the bubble has sent consumption plummeting, leading to the loss of an additional $500 billion a year in annual demand.
The hole from the collapse of construction and the falloff in consumption is more than $1 trillion a year. The government is the only force that can make up this demand. However, this means running large deficits. To boost the economy, the government must spend much more than it taxes. The stimulus approved by Congress last year was a step in the right direction this way, but it was much too small. After making adjustments for some technical tax fixes and pulling out spending for later years, the stimulus ended up being around $300 billion a year. Even this exaggerates the impact of the government sector, since close to half of the stimulus is being offset by cutbacks and tax increases at the state and local level.
The answer in this situation should be simple: more stimulus. But the deficit hawks have gone on the warpath insisting that we have to start worrying about bringing the deficit down. They have filled the airwaves, print media and cyberspace with solemn pronouncements about how the deficit threatens to impose an ungodly burden on our children.
This is of course complete nonsense. Larger deficits in the current economic environment will only increase output and employment. In other words, larger deficits will put many of our children's parents back to work. Larger deficits will increase the likelihood that parents can keep their homes and provide their children with the health care, clothing, and other necessities for a decent upbringing. But the deficit hawks would rather see our children suffer so that we can have smaller deficits.
In spite of the deficit hawks' whining, history and financial markets tell us that the deficit and debt levels that we are currently seeing are not a serious problem. The current projections show that, even ten years out on our current course, the ratio of debt to GDP will be just over 90 percent. The ratio of debt to GDP was over 110 percent after World War II. Instead of impoverishing the children of that era, the three decades following World War II saw the most rapid increase in living standards in the country's history.
We can also look to Japan, which now has a debt to GDP ratio of more than 180 percent. Investors are not running from Japanese debt. They are willing to hold long-term debt at interest rates close to 1.5 percent. In our own case, the 3.7 percent interest rate on long-term Treasury bonds remains near a historic low. The story is that we are forcing people to be out of work - unable to properly care for their children - because people like billionaire investment banker Peter Peterson and his followers are able to buy their way into and dominate the public debate. The reality is that we have an unemployment crisis today, not a deficit crisis. The only crisis related to the deficit is that people with vast sums of money (i.e. the people who wrecked the economy) have been able to use that money to make the deficit into a crisis.
The Problem Of Exponential Debt
by The Pragmatic Capitalist
A Chinese proverb known by Americans as the “Chinese curse” says: “may you live in interesting times”. Boy do we live in interesting times. This is a veritable golden age in economic evolution. New theories are being crafted as we speak and old theories that have stood the test of (our short) economic time are being torn down. No theory has come under fire in recent years like Keynesianism. After decades of success, Keynesianism doesn’t appear to be having the same magical effect. Economic theorists are confused. To their dismay (and with all apologies to Sir John Templeton, to whom I promised I would never utter these words) – it’s different this time. Literally.
We are fighting a very rare and wretched economic beast. As Bernanke’s great reflation experiment has ripped higher I have maintained that the hyperinflationists are wrong. Though we appear to have slipped through the hands of the balance sheet depression Grim Reaper, the balance sheet recession continues to nip at our heels. At his side always is his good friend Deflation.
A balance sheet recession is so rare that it has only occurred a handful of times in modern economic times. And thus far, he remains undefeated by all of the powerful economic minds who have stood in his path. In his path today is the great Sir John Maynard Keynes. The global economy has stood behind the theories of Lord Keynes as the economy has tumbled and Central Bankers have literally bet their printing presses on his theories. I fear they are not working and could be setting the table for an even greater catastrophe.
Over the course of the last 75 years governments around the globe have implemented policies of print and spend in times of economic downturns with great success. The truth is – Keynesianism works – in the right environment. It works well when debt is fairly low and organic economic growth is relatively strong, but exponential debt growth becomes an increasing concern every time you print your way out of an economic downturn. The larger the downturn, the larger the response. So on and so forth. If you happen to enter a period of severe irrationality and spending the problems multiply. If the recovery period is not used to pay down debts the problems become exponentially worse. The tipping point comes when the debt burden hinders future economic growth and destroys your ability to spend your way out of any future recessions. It effectively turns into one great pyramid scheme if it you let it get out of hand.
Marc Faber believes we are already there. He refers to the current period in U.S. history as “zero hour” – the point where we have indebted ourselves so deeply that we can’t be trusted to pay off our debts. Perhaps worse, however, is the inability to fend off future economic downturns. Not everyone agrees with this perspective, however.
Paul Krugman argues that the deficit worrying is entirely political. He’s correct to a certain extent, but as someone who loathes politics and understands that money has no political party I can say, without bias, that Krugman is also wrong to a large extent. Krugman argues that the economic downturn caused much of the current budget deficit – as if that somehow justifies it. But therein lies the problem. The prior Keynesian responses became multiplied and directly contributed to the current downturn. 20 years of easy money and accommodative print and spend monetary and fiscal policies have finally boiled over. In essence, we have tried to print and spend our way out of one too many recessions while failing to use the recovery periods to pay down our debts.
The problem is, as the United States economy has matured we have become increasingly confident of future growth and increasingly less fiscally prudent. The following chart shows the decade change in debt, GDP and debt/GDP. What was once a sustainable ratio in the 50’s, 60’s and 70’s has ballooned in the 80’s, 90’s and 00’s. The story in the private sector is largely the same as debt ratios have ballooned in the 90’s and 00’.
Now, as the recovery remains weak and worries of a double dip increase, Krugman and the other Keynesians are saying we’re not spending enough:
“The point is that running big deficits in the face of the worst economic slump since the 1930s is actually the right thing to do. If anything, deficits should be bigger than they are because the government should be doing more than it is to create jobs.”
Talk about doubling down on a losing bet….The truth of the matter is the U.S. economy is on an unsustainable path and our Keynesian economic responses have been large contributors. As the U.S. economy has matured and growth has slowed our spending has actually picked up pace. As we became more wealthy as a society we began to price-in increasing wealth expansion and with it came more debt – and more risk. That’s all well and good until the revenues begin to fall off a bit and then the debts become a substantial constraint.
Reinhart and Rogoff recently published a paper titled “growth in a time of debt”. They found that debt at 90% of GDP begins to substantially impact future economic growth:
“The relationship between government debt and real gross domestic product (GDP) growth has been weak for debt/GDP ratios below a threshold of 90% of GDP. Above 90%, median growth rates fell by one percentage point and average growth fell considerably more. The threshold for public debt was similar in advanced and emerging economies.”
With the budget expected to reach 95% of GDP this year we are nearing the point of no return. Not only will the public debt severely hinder our ability to grow our way out of the debt crisis, but this continued growth in debt will severely hinder our response to future downturns. Remember, I am not an anti-Keynesian. I simply don’t believe it is applicable in times of a balance sheet recession.
Krugman argues that there is no need to panic about the debts now:
“But there’s no reason to panic about budget prospects for the next few years, or even for the next decade.”
The Rogoff and Reinhart study shows that Krugman is wrong. The time to worry about the deficit is right now. Unfortunately, the Keynesian policies which Krugman has promoted, not only contributed to the current downturn, but severely cripple the U.S. economy going forward. Doubling down or continuing such policies has the potential to create subsequent economic downturns – downturns which we won’t have the option to print a trillion dollars in response to.
My greatest issue with U.S. monetary & fiscal policy over the last decade is a continuing lack of risk management (something, ironically, which is all too prevalent in the money management business as well). We continue to run up massive debts based on false economic growth assumptions. Like the consumer who assumed the 90’s would continue forever, (or the banker who created mortgage backed securities assuming real estate could never decline) we continue to spend assuming future growth will be high and recessions will be rare occurrences. What our policymakers should be asking themselves is how we can best prepare for the worst should the economy grow at a lower than average rate and downturns become more common occurrences. Instead, they continue asking themselves how quickly we can return to the go-go 90’s.
There is little doubt that Keynesianism works in a time of low debt and stable GDP growth, but this balance sheet recession is different. And it requires a different solution. A solution that politicians with short terms in office do not have the stomach (or time) to deal with.
In sum, the idea that you can turn on the debt spigot every time your economy gets into trouble is deeply flawed. The major flaw in the Keynesian approach is that it ignores exponential growth in debts. As a government continually spends and prints to get themselves out of one recession the debt they incur slowly hinders their ability to overcome any impending economic woes. Should they continue to attempt to print and spend their way out of each subsequent recession it becomes a negative feedback loop. The debt hinders future economic growth, the potential for subsequent downturns actually increases and the ability to handle those downturns is severely reduced. If fiscal imprudence continues in times of recovery you end up right where we are today.
Richard Koo, who has helped the Japanese deal with their own devastating balance sheet recession, believes we can spend our way out of this debt crisis. I disagree. At this point, our only option appears to be regulatory overhaul and belt tightening – and for a bloated U.S. economy that could mean substantial short-term economic pain. On the bright side, a little short-term pain will help us in removing the excesses that hinder the economy and will help to lay the foundation for the next great bull market. Unfortunately, the great Keynesian minds of our day continue to push these failed policies and the politicians in charge are unlikely to bite the bullet given their short-term needs for re-election and instant gratification. That likely means we confront increasing chances of facing our own “zero hour” and the more we spend the worse we can expect that event to be.
We live in most interesting times, and unfortunately, they are “cursed” not by the times we live in, but by the people who are crafting the economic policies of the times. This is not the time for more spending. Disastrously , I fear that our flawed response of bailing out the banks has already hindered our ability to recover. It would take a great leader and great economic mind to deviate from the flawed paths we have chosen. Unfortunately, in these “cursed” times neither appears to be in existence.
Britain's economy now as bad as 1970s, JP Morgan warns
Britain's economy is now in a comparable state to the 1970s when the country had to be bailed out by the International Monetary Fund, one of the world’s biggest investment banks has warned. JP Morgan said that in “many” ways “the UK’s fiscal position is currently worse than observed around the IMF loan in 1976”. The bank warns that Government debts, when compared to the total size of the economy, are higher than during the 1970s crisis. It adds that there could be a “marked fall” in the value of the pound as international investors re-assess the health of the British economy.
The intervention from JP Morgan is likely to add to the pressure on Gordon Brown and Alistair Darling to set out how they intend to cut Britain’s deficit. JP Morgan is one of the biggest banks in the world with assets of more than $2 trillion – almost as big as the entire British economy. Tony Blair is a consultant to the firm. The Conservatives have warned that Britain faces bankruptcy if public spending is not cut. In 1976, Britain was forced to turn to the International Monetary Fund (IMF) for a £2.3 billion bailout. In return for the funds, the IMF insisted on reforms to the British economy including public spending cuts. The period was regarded as one of the most humiliating in the history of the British economy.
In a research note entitled “UK Fiscal Policy: some lessons from the 1976 crisis”, JP Morgan said: “On many metrics, the UK’s fiscal position is currently worse than observed around the IMF loan in 1976…The size of the current budget deficit suggests that the UK is leaning heavily on the credibility it has built up since the mid-1970s.” The bank’s “central forecast” is that Britain will “muddle through” the crisis. However, JP Morgan added: “The possibility that markets could take a more severe view of the fiscal position is clear, and the 1976 experience demonstrated that the situation can change quickly and unpredictably.
“Officials fretted over the possibility of a marked fall in the currency well before the crisis. Looking back at 1976, one can argue that as the crisis broke, the underlying situation had actually begun to improve (growth had begun to recover and current account deficits had begun to fall).” There are growing fears about the high level of Government borrowing which is causing turmoil on financial markets in this country and throughout Europe. The value of the pound has recently fallen sharply against the dollar. European leaders will meet later this week to discuss the financial crisis in Greece. Greek public debts are crippling the economy and have prompted concerns over the euro as wealthier European countries may be forced to bail-out the beleaguered nation.
Britain has now been branded one of the “STUPID” countries – Spain, Turkey, United Kingdom, Portugal, Italy and Denmark – whose “excessive” Government borrowing is now threatening the economy. Total Government borrowing in this country is due to top £1 trillion in the next few years. Mr Brown insists that increased borrowing has allowed the Government to invest during the recession and stop unemployment rising as fast as feared. Ministers have pledged to cut the deficit in half over the next four years but have yet to spell out exactly how this will be achieved.
How Brussels Is Trying to Prevent a Collapse of the Euro
The problems facing Greece are just the beginning. The countries belonging to Europe's common currency zone are drifting further and further apart with national bankruptcies a distinct possibility. Brussels is faced with a number of choices, none of them good. Men like Wilhelm Nölling, former member of the German Central Bank Council, and Wilhelm Hankel, an economics professor critical of the euro, have been out of the spotlight for years. In the 1990s, they fought against the introduction of the common currency, even calling on Germany's high court to prevent the creation of the euro zone. But none of it worked.
Now both men are in demand again, and the old euro critics' beliefs are more relevant than ever. Were the skeptics right back then, when they said Europe wasn't ready for the euro zone? Were the differences too great and the politicians too weak to ensure a strict and stable course? "The euro should really be called the Icarus," Hankel suggested back then. He predicted the currency would meet the same end as the hero of Greek legend, who paid for his dream of flight with his life.
Is the euro's high flight over now too? The news these days is alarming. It's causing a commotion on financial markets and intense discussion in capitals across Europe, as well as in Frankfurt, seat of the European Central Bank (ECB). Brussels took a hard line with Athens last week. Greece must cut costs drastically under close European Union supervision, a sacrifice of a share of its sovereignty. Risk premiums for Greek government bonds have risen drastically and the country has to pay higher and higher charges.
The Possibility of State Bankruptcies
Accruing debt is becoming increasingly expensive for other countries in the euro zone as well, among them Portugal and Spain. The southern members of the euro zone especially are being eyed with mistrust. Speculators are betting that bonds will continue to fall and that, eventually, the countries won't be able to borrow any more money at all. State bankruptcies are seen as a possibility. "We've reached a point where it's possible to deal individual countries a lethal blow by downgrading their credit and boycotting their government bonds," Nölling warns.
Many are now wondering how the stronger euro zone countries should react -- whether it's possible to help the weaker ones without jeopardizing themselves and the common currency. Furthermore, there is a risk that euro zone members will continue to grow apart economically, a trend that could cause the monetary union to eventually collapse. Doing nothing is not an option. In light of the national debt in Greece, Portugal, Spain, and Ireland, the euro zone is in danger of transforming from a "common destiny to a common liability," Nölling says. And so it won't be any ordinary meeting when finance ministers from the 16 euro zone countries meet for a regularly scheduled get-together in Brussels next Monday. The European Commission plans to assign each country homework to be completed in the coming years.
Cohesion and Stability
The Commission doesn't hold Greece alone responsible for the current euro woes. Experts close to Economic and Monetary Affairs Commissioner Joaquín Almunia say nearly every participating country is compromising the cohesion and stability of the common currency. "The combination of decreasing competitiveness and excessive accumulation of national debt is alarming," the experts wrote in a recent report, adding that if the member countries don't get their problems under control, it will "jeopardize the cohesion of the monetary union."
Differing economic development within the euro zone and a lack of political coordination are to blame, they say. In the more than 10 years since the euro was introduced, the Commission states, it has become clear that simply controlling the development of member states' budgets is not enough. What that means, more concretely, is that the stability provisions stipulated in the Maastricht Treaty to regulate the common currency aren't working and member states need to better coordinate their financial and economic policy measures.
That is precisely what euro skeptics have said from the beginning -- that a common currency can't work in the long run without a common economic and financial policy. The member countries' governments ignored these objections, unready to give up a further aspect of their national sovereignty. Now politicians are facing a difficult decision: Should they continue as they have, thus potentially undermining the euro's ability to function? Or should they yield a portion of their national sovereignty to Brussels? Without common policies, the individual countries drift further and further apart. Before the euro was introduced, exchange rate adjustments served to dispel tensions. Now the common currency zone lacks the option of adapting by revaluing currencies.
Watching with Alarm
EU officials are watching with alarm as the various euro zone countries' competitiveness diverges sharply. The differences are especially large between countries like Germany, the Netherlands and Finland, which are characterized by current account surpluses, and countries with high budget deficits. Along with Greece, this second category includes especially Spain, Portugal, and Ireland. These countries' competitiveness has dropped steadily since the euro was introduced. They lived on credit for years, seduced by the unusually low interest rates within the euro zone, and imported far more than they exported.
When demand collapsed in the wake of the global financial crisis, governments jumped in to fill the gap, with serious consequences -- debt skyrocketed. Spain's budget deficit was at 11 percent last year, while Greece's was nearly 13 percent. Such high debt is simply not sustainable in the long term. In the past, the solution for these countries would have been to devalue their currency, which in turn would make imports more expensive and exports cheaper. Such a move would stimulate their national economies and strengthen their competitiveness.
Now, however, these countries must submit to a drastic cure at the hands of the European Commission. They need to balance their budgets, while simultaneously creating more competition on the labor market and on the goods market. The guidelines from Brussels translate to difficult sacrifices for the citizens of those countries affected. Employees will have to scale back wage demands for years and civil servants will see their salaries cut. Ireland has already embarked on this path -- Greece and Spain will follow.
How Brussels Is Trying to Prevent a Collapse of the Euro - PART 2: Is Germany to Blame?
The Commission has recommended that Spain, booming until recently, radically restructure its economy. Spain must significantly shrink its bloated construction sector and focus on economic sectors with higher productivity. France and Italy have been given homework assignments of their own. Both countries are being asked to apply austerity packages and increase labor market flexibility. France must also get its significant welfare and unemployment expenses under control.
Resentment is growing in the countries most directly affected. But that frustration is not directed, as might be expected, toward the Commission. Instead, it is increasingly surplus countries coming under fire -- with Germany at the forefront. Representatives from Spain and Portugal especially -- but also from France -- hold Germany accountable for their current woes. They aren't alone in that opinion either. "The Greek crisis has German roots," says Heiner Flassbeck, chief economist at the United Nations Conference on Trade and Development (UNCTAD) in Geneva. It was German wage dumping that got the country's European neighbors in trouble, he says.
At Its Neighbors' Expense
EU officials don't phrase it quite so strongly, but they still accuse Germany more than any other country of gaining advantages for itself at its neighbors' expense, using its policy of low wages to make German products increasingly attractive relative to those from other countries. As a precautionary measure, officials at Berlin's Finance Ministry have gathered arguments that Finance Minister Wolfgang Schäuble can put forward in the country's defense.
Germany's position is that the countries now in crisis are themselves at fault for their situation. They lived beyond their means for years, the German government says, financing their economic boom on credit. Now the financial crisis has revealed their weaknesses. Germany didn't have it easy with the euro in the beginning either, continues the argument, because the country wasn't competitive compared to other member countries -- but it regained its strength with a great deal of trouble and effort, through reforms.
German officials point to the fact that the country made its labor market more flexible through the Hartz package of welfare reforms and say that state finances are more stable than before, despite the crisis. They add that taking this same path would lead the currently troubled countries out of the crisis. And, they continue, the federal government is not responsible for lagging wage growth, because in Germany, salaries and wages are negotiated between employers and unions, not imposed by the government. The German government also claims no responsibility for the country's export surplus. German firms are competitive not because of government policy, it says, but because of entrepreneurial decisions and the preferences of customers around the world.
Create More Competition
When this debate flared up recently within the euro zone countries, Schäuble received support from the top for his position. The southern members of the euro zone shouldn't be ungrateful, warned ECB President Jean-Claude Trichet. After all, Germany funded the deficits with its surpluses. Nonetheless, the Commission called on Germany to make further changes as well. The country should boost domestic demand, increase investment in infrastructure and create more competition in the service sector. The Commission believes the currency union can exist in the long term only if member countries' governments implement reforms and coordinate their economic policies in the future. Schäuble's experts agree. They are proposing -- partly with an eye toward mollifying France -- a common German-French initiative.
Both countries' governments should work toward better coordination, the German financial experts say. Merely monitoring deficits has turned out to be inadequate. In the future, they suggest, euro zone governments should also focus on combating differing inflation rates and step in early when capital bubbles develop. France, no doubt, would gladly accept such a proposal. Paris, after all, has long called for Europe-wide financial governance. Until now it was Germany that opposed the idea. The euro zone governments have started to rethink their positions, but will action necessarily follow? The past never lacked in good intentions either, but political calculation always won out in the end. How else would Greece have managed to become a member of the common currency? Why else would Brussels stand by for so long without taking action? It was far from secret that Greece had been cooking its books for years.
Back in the fall of 2004, Eurostat, the EU body in charge of statistics, calculated that Greece's officially announced debts of between 1.4 percent and 2.0 percent of gross domestic product between 2000 and 2003 were incorrect. In reality, the amount was nearly three times as high, falling between 3.7 and 4.6 percent. The statisticians surmised that Athens had whitewashed its finances in previous years too. Greece, in fact, would never have met the conditions for membership in the common currency without such trickery. But the country was not immediately banned from the euro zone, nor were other sanctions imposed. Instead, member countries discussed how the statistics could be improved and made more accurate. Not much emerged from all the talk.
Outgoing European Commissioner for Enterprise and Industry Günter Verheugen remembers all too well that for a long time, the problem with Greece was simply not something that was talked about. He finds it hard to believe that this "disproportionate regard" for Greece had nothing to do with that fact that conservative allies of European Commission President José Manuel Barroso governed in Athens for five years. Not until last fall's elections brought Greece's socialist opposition to power did new data arrive from Athens -- and new questions and accusations from Brussels. The Greek parliament and government are now virtually stripped of power. They're not allowed to decide on any new expenditures without EU approval. Finance Minister Giorgos Papakonstantinou is required to report every four weeks on progress made in budget restructuring.
An EU Protectorate
Brussels, not Athens, now controls whether and how the austerity program takes effect. If "detailed and ongoing inspection" shows that the actual results fall short of those predicted, Almunia says, then Brussels' watchdogs will demand further measures. There were even calls at the European Parliament last week to send a special EU representative with extensive authority to Greece. The small country has become little more than an EU protectorate. The EU Commission and the euro zone leaders hope these compulsory measures will steady markets. They also hope Greek unions and associations, from farmers to taxi drivers, won't mobilize against the reduction in the country's standard of living that will accompany these new measures.
German Finance Minister Schäuble and German Federal Bank President Axel Weber rule out aid to the struggling country. Indeed, EU treaties strictly forbid any such aid. The message is that Greece must help itself. As a precautionary measure, though, both German officials, along with their colleagues in other EU countries, are keeping open the possibility of lending a hand anyway. The EU can't afford for a member state to go bankrupt, neither politically nor economically.
Out of the Question
The experts always debate the same possibilities. The first would be a common euro zone bond, which would be placed at Greece's disposal. The advantages for Greece are obvious -- the country would receive funds more cheaply than it currently does, because the euro zone as a whole wouldn't have to pay as high a risk premium as Greece alone does. The disadvantage is that countries with good credit, like Germany, would have to pay higher interest rates. The German government insists that such a loan is out of the question. An alternative would be bilateral financial aid. Solvent countries such as Germany would take out loans on the financial market at good rates and pass these on to Greece. The euro zone governments are also reluctant to take this path.
The last option is the International Monetary Fund (IMF), which could use its resources to help Greece out of its credit crunch. It would likely impose much stricter conditions on its aid money than the EU would. But the IMF's involvement would also mean a loss of face for the entire euro zone and a triumph for the Washington-based institution, which was always skeptical of the euro. If Greece doesn't stabilize in the coming weeks, the euro zone's leaders will be left facing a choice between a rock and a hard place, with the third option being even worse.
How Goldman Sachs Helped Greece to Mask its True Debt
Goldman Sachs helped the Greek government to mask the true extent of its deficit with the help of a derivatives deal that legally circumvented the EU Maastricht deficit rules. At some point the so-called cross currency swaps will mature, and swell the country's already bloated deficit.
Greeks aren't very welcome in the Rue Alphones Weicker in Luxembourg. It's home to Eurostat, the European Union's statistical office. The number crunchers there are deeply annoyed with Athens. Investigative reports state that important data "cannot be confirmed" or has been requested but "not received."
Creative accounting took priority when it came to totting up
Since 1999, the Maastricht rules threaten to slap hefty fines on euro member countries that exceed the budget deficit limit of three percent of gross domestic product. Total government debt mustn't exceed 60 percent.
The Greeks have never managed to stick to the 60 percent debt limit, and they only adhered to the three percent deficit ceiling with the help of blatant balance sheet cosmetics. One time, gigantic military expenditures were left out, and another time billions in hospital debt. After recalculating the figures, the experts at Eurostat consistently came up with the same results: In truth, the deficit each year has been far greater than the three percent limit. In 2009, it exploded to over 12 percent.
Now, though, it looks like the Greek figure jugglers have been even more brazen than was previously thought. "Around 2002 in particular, various investment banks offered complex financial products with which governments could push part of their liabilities into the future," one insider recalled, adding that Mediterranean countries had snapped up such products.
Greece's debt managers agreed a huge deal with the savvy bankers of US investment bank Goldman Sachs at the start of 2002. The deal involved so-called cross-currency swaps in which government debt issued in dollars and yen was swapped for euro debt for a certain period -- to be exchanged back into the original currencies at a later date.
Fictional Exchange Rates
Such transactions are part of normal government refinancing. Europe's governments obtain funds from investors around the world by issuing bonds in yen, dollar or Swiss francs. But they need euros to pay their daily bills. Years later the bonds are repaid in the original foreign denominations.
But in the Greek case the US bankers devised a special kind of swap with fictional exchange rates. That enabled Greece to receive a far higher sum than the actual euro market value of 10 billion dollars or yen. In that way Goldman Sachs secretly arranged additional credit of up to $1 billion for the Greeks.
This credit disguised as a swap didn't show up in the Greek debt statistics. Eurostat's reporting rules don't comprehensively record transactions involving financial derivatives. "The Maastricht rules can be circumvented quite legally through swaps," says a German derivatives dealer.
In previous years, Italy used a similar trick to mask its true debt with the help of a different US bank. In 2002 the Greek deficit amounted to 1.2 percent of GDP. After Eurostat reviewed the data in September 2004, the ratio had to be revised up to 3.7 percent. According to today's records, it stands at 5.2 percent.
At some point Greece will have to pay up for its swap transactions, and that will impact its deficit. The bond maturities range between 10 and 15 years. Goldman Sachs charged a hefty commission for the deal and sold the swaps on to a Greek bank in 2005.
The bank declined to comment on the controversial deal. The Greek Finance Ministry did not respond to a written request for comment.
The Ever Increasing Parallels Between AIG And Greece... And The CDS Puppetmaster Behind It All
by Tyler Durden
David Fiderer's below piece, originally published on the Huffington Post, continues probing the topic of Goldman and AIG. For all intents and purposes the debate has been pretty much exhausted and if there was a functioning legal system, Goldman would have been forced long ago to pay back the cash it received from ML-3 (which in itself should have been long unwound now that plans to liquidate AIG have been scrapped) and to have the original arrangement reestablished (including the profitless unwind of AIG CDS the firm made improper billions on, by trading on non-public, pre-March 2009, information), and now that AIG is solvent courtesy of the government, so too its counterparties can continue experiencing some, albeit marginal, risk, instead of enjoying the possession of cold hard cash. Oh, and Tim Geithner would be facing civil and criminal charges.
Yet as we look forward, we ask, who now determines the variation margin on Greek CDS (and Portugal, and Dubai, and Spain, and, pretty soon, Japan and the US), the associated recovery rate, and how much collateral should be posted by sellers of Greek protection? If Greek banks, as the rumors goes, indeed sold Greek protection, and, as the rumor also goes, Goldman was the bulk buyer, either in prop or flow capacity, it is precisely Goldman, just like in the AIG case, that can now dictate what the collateral margin that Greek counterparties, and by extension the very nation of Greece, have to post on billions of dollars of Greek insurance.
Let's say Goldman thinks Greece's debt recovery is 75 cents and the CDS should be trading at 700 bps, instead of the "prevailing" consensus of a 90 recovery and 450 spread, then it will very likely get its way when demanding extra capital to cover potential shortfalls, since Goldman itself has been instrumental in covering up Greece's catastrophic financial state and continues to be a critical factor in any future refinancing efforts on behalf of Greece. Obviously this incremental margin, which only Goldman will ever see, even if the CDS was purchased on a flow basis, will never be downstreamed on behalf of its clients, and instead will be used to [buy futures|buy steepeners|prepay 2011 bonuses|buy more treasuries for the BONY $60 billion Treasury rainy day fund].
In essence, through its conflict of interest, its unshakable negotiating position, and its facility to determine collateral requirements and variation margin, Goldman can expand its previous position of strength from dictating merely AIG and Federal Reserve decision making, to one which determines sovereign policy! This is unmitigated lunacy and a recipe for financial collapse at the global level.
This is yet another AIG in the making, with Goldman this time likely threatening to accelerate the collapse not merely of the US financial system, but of the global one, in order to attain virtually infinite negotiating leverage. Of course, the world will not allow a Greece-initiated domino, allowing Goldman to call everyone's bluff once again.
As the amount of gross and net sovereign CDS notional is constantly increasing, as more and more hedge funds join the shorting fray with Goldman as the intermediate (just like in AIG), it behooves any remaining regulators and any sensible Federal Reserve parties to supervise precisely what the terms of Goldman's collateral margins with various sovereign debt sellers are, especially when it pertains to increasingly distressed CDS, where a liquidity squeeze, again as in the AIG case, would have tremendous adverse downstream consequences. If indeed Goldman's counterparties are the banks of respective countries, then the parallels with AIG are nearly complete. And we all know what happened then.
Furthermore, we are now convinced that Goldman will join the government in facilitating the engineered market swoon with a bifurcated goal: while the Treasury will take advantage of a sell off to offload as many UST as it can in the rush for safety (which could backfire now that Gold is increasingly seen as a dollar alternative), Goldman (with or without Warren Buffett - it depends on what the actuarial tables say) will jettison its own stock price in order to go private in an increasingly hostile world.
We will discuss all these issue further in the near future, and in the meantime David Fiderer provides yet another nail in the AIG-Goldman coffin.
The Times Story On Goldman's Role in AIG's Downfall Is More Damning When Placed In Context
by David Fiderer
Placed in a broader context, the front page story in the The New York Times is even more damning of Goldman Sachs than readers might realize. Goldman played an active role in the destruction of AIG. During Hank Paulson's tenure as the firm's CEO, Goldman engaged in a series of sham transactions designed to give the false impression that it was buying credit default swaps as an instrument for risk management. In fact, it acquired those swaps in order to double down on bets against collateralized debt obligations, or CDOs, which it knew to be fatally flawed. In the latter part of 2008, Paulson and his proxies maneuvered AIG into a liquidity crisis in order to protect Goldman at the expense of the U.S. taxpayer.
To appreciate how the Times piece fits into a larger picture, you need to understand why these CDOs were so obviously toxic.
The Fatal Flaw Of These CDOs
AIG went bust because it sold credit default swaps for CDOs stuffed with slices of subprime mortgage bonds. Those subprime mortgage bonds all had remarkably similar capitalization structures, divided among different classes, or tranches, of seniority. The top 80% in seniority had a credit rating of AAA. The bottom 10% was rated A and below.
The bottom 10% was especially vulnerable because of something that was an open secret at the time. The subprime mortgage market was riddled with fraud. So the data used by Goldman and others to structure these bond deals was highly suspect.
Who bought the bottom 10% of these subprime bond deals? A lot of those lower-rated tranches were not sold directly to investors. Rather they were stuffed into CDOs. This point is critical. These CDOs were not comprised of mortgage loans, or even slices of mortgage loans. Rather, they held deeply subordinated claims on risky subprime mortgages. Because these tranches were the last ones to get repaid, it was easy to foresee, at the time these CDOs were put together, that investors would lose significant amounts of principal.
People marketing these CDOs claimed that they were safe, because the risks were diversified, and because of excess collateral cover. But that line of reasoning never made any sense. The lower rated tranches were like the passengers in steerage on the Titanic. Once the ship starting sinking, those passengers were the last ones given access to the lifeboats. As soon as the housing market started sinking, those lower-rated tranches would be the last ones given access to any foreclosure proceeds.
AIG thought it was selling credit protection for AAA risk. And in fact, these CDOs, like subprime mortgage bonds, were tranched in a way that made them top heavy with AAA ratings. Consider, for example, for Adirondack 2005-2, a CDO arranged by Goldman, which "sold" almost all of the AAA tranche Societe Generale, which in turn bought credit protection from AIG. Of Adirondack 2's $1.55 billion capitalization, $1.42 billion, or 91%, was rated AAA.
So how could anyone get comfortable with the notion that 90% of a portfolio, heavily weighted with deeply subordinated claims on risky mortgages that were likely to be infected with fraud, represented a AAA-quality credit risk? It's a question for which there is no good answer. If anyone looking at these deals had done proper due diligence and done a common-sense analysis of the structural risks, he would have realized three things:
1. The original credit ratings for lower-rated slices of these subprime bond deals were meaningless;
2. The original credit ratings on these CDOs were even more meaningless; and
3. The CDOs were destined in fail in a big and obvious way.
Goldman's Malign Intent
Obviously, the people at AIG never figured out what was going on until it was too late. But there's a mountain of circumstantial evidence that the people at Goldman had a keen grasp of the fatal flaws of these CDOs, which they structured. The Times piece is a major addition to that mountain of evidence:[Former AIG executive Alan] Frost cut many of his deals with two Goldman traders, Jonathan Egol and Ram Sundaram, who had negative views of the housing market. They had made A.I.G. a central part of some of their trading strategies.
Mr. Egol structured a group of deals -- known as Abacus -- so that Goldman could benefit from a housing collapse. Many of them were actually packages of A.I.G. insurance written against mortgage bonds, indicating that Mr. Egol and Goldman believed that A.I.G. would have to make large payments if the housing market ran aground. About $5.5 billion of Mr. Egol's deals still sat on A.I.G.'s books when the insurer was bailed out.
"Al probably did not know it, but he was working with the bears of Goldman," a former Goldman salesman, who requested anonymity so he would not jeopardize his business relationships, said of Mr. Frost. "He was signing A.I.G. up to insure trades made by people with really very negative views" of the housing market.
As further evidence that Goldman used AIG to profit by shorting CDOs, rather than to manage its preexisting risk exposure:[N]egotiating with Goldman to void the A.I.G. insurance was especially difficult, Federal Reserve Board documents show, because the firm did not own the underlying bonds. As a result, Goldman had little incentive to compromise.
Goldman's seven Abacus deals [Abacus 2004-1, Abacus 2004-2, Abacus 2005-2, Abacus 2005-3, Abacus 2005-CB1, Abacus 2006-NS1, Abacus 2007-18] were unique among all the CDOs in AIG's portfolio. For all the other deals, the collateral manager, the entity that oversaw and managed the CDO after closing, was entirely independent from the bank that originally arranged and structured the transaction. For all the Abacus deals, Goldman acted both as both the arranging bank and the collateral manager. This is no small technicality. In other Abacus deals, Abacus 2006-13 and Abacus 2006-17, Goldman used its "sole discretion" to retire lower rated CDO tranches without regard to seniority. This approach, under documentation drafted by Goldman, upends the entire premise of structured finance.
Most importantly, the government never purchased the Abacus deals when it bought $62.1 billion other CDOs at par, back in November 2008. Why didn't the parties feel a need to take the Abacus deals off of AIG's balance sheet? It's an extremely important question, for which we will not have an adequate answer until we see the actual documentation, specifically: the offering memoranda, the performance reports and swap agreements.
Hiding Behind Societe Generale
The Times story also suggests that Goldman used Societe Generale as a front, to conceal from Frost and others the size of their cumulative bet against these CDOs.Mr. Sundaram's trades represented another large part of Goldman's business with A.I.G. According to five former Goldman employees, Mr. Sundaram used financing from other banks like Societe Generale and Calyon to purchase less risky mortgage securities from competitors like Merrill Lynch and then insure the assets with A.I.G. -- helping fatten the mortgage pipeline that would prove so harmful to Wall Street, investors and taxpayers. In October 2008, just after A.I.G. collapsed, Goldman made Mr. Sundaram a partner.
Through Societe Generale, Goldman was also able to buy more insurance on mortgage securities from A.I.G., according to a former A.I.G. executive with direct knowledge of the deals. A spokesman for Societe Generale declined to comment.
It is unclear how much Goldman bought through the French bank, but A.I.G. documents show that Goldman was involved in pricing half of Societe Generale's $18.6 billion in trades with A.I.G. and that the insurer's executives believed that Goldman pressed Societe Generale to also demand payments...On Nov. 1, 2007, for example, an e-mail message from Mr. Cassano, the head of A.I.G. Financial Products, to Elias Habayeb, an A.I.G. accounting executive, said that a payment demand from Societe Generale had been "spurred by GS calling them."
As noted earlier in the story:In addition, according to two people with knowledge of the positions, a portion of the $11 billion in taxpayer money that went to Societe Generale, a French bank that traded with A.I.G., was subsequently transferred to Goldman under a deal the two banks had struck.
See here for an analysis of the ten-figure purchases and sales between Goldman and SG.
The AAA Pyramid Scheme Embedded Inside AIG
The Times reports that Goldman tailored the terms of the swaps to exploit these defective credit ratings:The terms, described by several A.I.G. trading partners, stated that A.I.G. would post payments under two or three circumstances: if mortgage bonds were downgraded, if they were deemed to have lost value, or if A.I.G.'s own credit rating was downgraded. If all of those things happened, A.I.G. would have to make even larger payments.
Here's an example of how terminology for a general news readership can lead to confusion. In the context of the story, the Times seems to be referencing the ratings of the CDOs, not the subprime bonds held by the CDOs. The distinction is critical because almost all subprime bonds were downgraded in 2007, whereas most of these CDOs were not downgraded prior to May 2008, when they received minor downgrades.
Most importantly, almost all these CDO tranches were rated AAA during November 2007, when, as the Times reports, Goldman was demanding billions in cash collateral. There is no way to reconcile a 40% diminution of value, which Goldman repeatedly asserted, with a AAA rating. It's like saying 2 + 2 = 11. In effect, Goldman was admitting that the CDOs' ratings were a joke.
It was an especially cruel joke on AIG and on the American taxpayer. If the ratings agencies had severely downgraded the CDOs in 2007 or earlier in 2008, AIG's day of reckoning would have come sooner. Instead, that day coincided with Lehman's bankruptcy. The ratings agencies announced their major downgrades of AIG after the close of business on September 15, 2008. Those downgrades triggered cash collateral calls and on AIG on September 16, 2008, the same day that a money market fund, which wrote down Lehman paper, broke the buck and triggered widespread panic in the money markets.
As noted before, the timing of the CDO downgrades looks suspicious. Eric Kolchinsky, a former managing director at Moody's, has alleged that the ratings agency deliberately and deceitfully delayed the announcements of downgrades of various CDOs. The House Oversight Committee is still investigating the matter.
Why Goldman Pressured AIG to Hand Over Cash
The thrust of the front-page Times article was that Goldman aggressively pressured AIG to hand over cash collateral beginning in 2007, Goldman asserted, because, the CDOs "were deemed to have lost value." But negotiations were always at an impasse, for an obvious reason. There was no way to settle on agreed-upon "market value" for the CDOs. These securities weren't bought or sold, like Treasuries or shares of IBM. Nor was there any market benchmark upon which the CDOs could be valued. The only way to set a price, according to auditors for AIG and the Federal Reserve, was according to internal valuation models.
The Times reports:[D]ocuments show there were unusual aspects to the deals with Goldman. The bank resisted, for example, letting third parties value the securities as its contracts with A.I.G. required. And Goldman based some payment demands on lower-rated bonds that A.I.G.'s insurance did not even cover. A November 2008 analysis by BlackRock, a leading asset management firm, noted that Goldman's valuations of the securities that A.I.G. insured were "consistently lower than third-party prices."
The Times reporting suggests that Goldman wanted to control the dispute by using a nominally independent third party, PricewaterhouseCoopers, which had shifted into Goldman's camp:Adding to the pressure on A.I.G., [David] Viniar, Goldman's chief financial officer, advised the insurer in the fall of 2007 that because the two companies shared the same auditor, PricewaterhouseCoopers, A.I.G. should accept Goldman's valuations, according to a person with knowledge of the discussions. Goldman declined to comment on this exchange.
Pricewaterhouse had supported A.I.G.'s approach to valuing the securities throughout 2007, documents show. But at the end of 2007, the auditor began demanding that A.I.G. provide greater disclosure on the risks in the credit insurance it had written. Pricewaterhouse was expressing concern about the dispute.
The insurer disclosed in year-end regulatory filings that its auditor had found a "material weakness" in financial reporting related to valuations of the insurance, a troubling sign for investors.
Of course, a highly plausible explanation is that Pricewaterhouse, like AIG, had assumed that the CDOs' AAA ratings were credible, until Goldman set them straight. But again, this gets back to the issue of whether Goldman knew these deals were toxic from the start. Goldman opposed proposals that would have enabled it to make its case to others:When A.I.G. asked Goldman to submit the dispute to a panel of independent firms, Goldman resisted, internal e-mail messages show. In a March 7, 2008, phone call, Mr. Cassano discussed surveying other dealers to gauge prices with Michael Sherwood, Goldman's vice chairman. At that time, Goldman calculated that A.I.G. owed it $4.6 billion, on top of the $2 billion already paid. A.I.G. contended it only owed an additional $1.2 billion.
Mr. Sherwood said he did not want to ask other firms to value the securities because "it would be 'embarrassing' if we brought the market into our disagreement," according to an e-mail message from Mr. Cassano that described the call. The Goldman spokesman disputed this account, saying instead that Goldman was willing to consult third parties but could not agree with A.I.G. on the methodology.
The dispute would have been more than embarrassing for Goldman. It would have shed light on the fatal flaws of these CDOs, which, at the time, were not known to the broader financial community. These flaws were not known because so few parties took a serious look at the credit risk, which was largely assumed by a handful of companies: AIG Financial Products (under a guarantee by its parent) and the monoline insurance companies. In early 2008, the monolines started settling their contingent CDO obligations for a fraction of par. As noted earlier, they were able to do so because they had the backing of their regulators. AIGFP, which was unregulated, was on its own. Ever prescient, Goldman never bought credit protection from the monolines.
Goldman did not "own" the cash it held. Rather, the cash represented margin that could, in theory, be returned to AIG if the CDOs' value rose again. Of course, in reality, if you hold the cash you have the upper hand in any negotiation. Also, the way structured finance deals work, if early credit losses are worse than expected, the diminution of value is permanent. The other borrowers in the pool, who never pay more than 100% of their principal and interest, won't make up the difference. Finally, as noted before, the cash collateral for derivatives, like credit default swaps, is very different than the cash collateral for a loan or other obligation. Goldman's claims had preferred treatment, another reason why, once it got its hands on the cash, it held the upper hand in any negotiation.
How Hank Paulson Used Proxies to Rig the Eventual Outcome
One thing is as certain as death and taxes. During 2007 and 2008 Edward Liddy was repeatedly briefed, at length, by Pricewaterhouse and by senior management at Goldman, about the firm's CDO exposure with AIG and about the valuation dispute. If the matter was so important that Goldman's CFO and vice chairman took an active role in negotiating the circumstances for simply attempting to resolve the dispute, then Ed Liddy thoroughly understood the matter and the stakes that were involved. This will all come out when Liddy's briefing books, and other related documentation and correspondence, are obtained by the House Oversight Committee, which is investigating this matter.
Liddy was the Chairman of the Audit Committee on Goldman's Board of Directors. Every audit committee of the board of every publicly held financial institution is briefed in depth about risk concentrations at the firm. There is no way that Pricewaterhouse would leave itself exposed by not thoroughly briefing Liddy about these matters. While it may be a part-time obligation, being Chair of the Audit Committee at Goldman is a very important job. And during one all-important week, Liddy did some moonlighting.
A few minutes after he spoke with Goldman's CEO, Lloyd Blankfein, on September 16, 2008, and shortly after he first considered a government bailout of AIG, Hank Paulson unilaterally decided that Liddy should immediately become AIG's new CEO. Unlike Liddy, AIG's CEO at the time, Bob Willumstad, had relatively clean hands in the CDO saga. Willumstad had been part of AIG's management for about three months, and had joined the AIG board in April 2006, when most of Goldman's toxic CDOs had already been insured by AIG.
That same afternoon, Liddy was on a plane to New York, to start at AIG the next day. Liddy was officially made CEO and Chairman of AIG on September 18. And of course, he immediately immersed himself into negotiating the terms of the government bailout facility, which he signed on September 22. Only on the following day, on September 23, 2008, that Liddy chose to make his resignation from Goldman's board effective.
That was also the week when Paulson spoke to Blankfein 24 times by phone. For further clarification at to why it an innocent explanation of all this is beyond any realm of plausibility, see this earlier piece.
"Who the heck is Dan Jester?" asked Times Opinionator columnist William D. Cohen, who answered his own question last week. Jester was the former Goldman deputy CFO who was plucked by Treasury Secretary Paulson in the summer of 2008 to act as his "contractor," i.e. someone for whom usual formalities pertaining to government accountability would not apply. But Tim Geithner made more calls to Jester, during the fall of 2008, than to any other bona fide Treasury employee, with the exception of Hank Paulson. Cohen writes:One former A.I.G. executive told me that Jester was calling many of the shots at the insurer between mid-September, when the New York Fed decided to go ahead with the bailout, and the end of October 2008, when Jester was replaced at A.I.G. by another Treasury official because, according to The New York Times, of Jester's "stockholdings in Goldman Sachs." "He was Paulson's man," the former A.I.G. executive told me. "He was the Treasury's representative, and he was at every meeting" during that mid-September weekend.
One of the shots being called during that period was the decision for AIG to hand over $18.7 billion in scarce cash to the CDO counterparties in exchange for zero concessions.At one point, on the following Monday, Sept. 15, as the A.I.G. situation was spiraling out of control, Jester phoned the three major credit-rating agencies and asked them to hold off from downgrading A.I.G. any further, since that additional downgrade would force the insurer to make even more collateral payments on the spot to counterparties, further depleting its dwindling cash. Jester's efforts weren't persuasive. "It was pathetic," the former A.I.G. executive told me.
There are many people who do not know how to speak forcefully and effectively to the rating agencies, but that group would not include a former deputy CFO from Goldman. It would be somewhat analogous to Katie Couric getting flustered when asked to read a teleprompter. There is no way that the agencies could have been aware of AIG's difficulties and not have been equally aware of their own role in contributing to those difficulties. Nor could they have been unaware that a downgrade would trigger AIG's liquidity crisis. On the same day that the markets were absorbing the shock from the Lehman bankruptcy, if the government asks the agencies to wait just a bit longer to see how the evolving situation plays out with regard to delicate negotiations for a private bank deal to provide new liquidity for AIG, the agencies would ordinarily be inclined to pause for a bit.
For those and other reasons, I believe Jester's feeble performance was deliberate, that the endgame was to trigger a liquidity crisis at AIG in order to force a government bailout, which would be a backdoor bailout of Goldman. The House Oversight Committee should review Jester's public and private emails and phone records to get more clarity on this point.
As Paulson wrote in his new book, "Much of my work was done on the phone, but there is no official record of many of the calls. My phone log has many inaccuracies and omissions." Why would the electronic records of his phone calls be inaccurate, or have any omissions? It's the sort of disclaimer Dick Cheney would give.
What the Past Tells Us
by David Walker
Perhaps because we are a young country, Americans tend not to pay much attention to the lessons of history. Well, we should start, because those lessons are brutal. Power, even great power, if not well tended, erodes over time. Nations, like corporations and people, can lose discipline and morale. Economic and political vulnerability go hand in hand. Remember, without a strong economy, a nation’s international standing, standard of living, national security, and even its domestic tranquility will suffer over time.
Many of us think that a superpowerful, prosperous nation like America will be a permanent fixture dominating the world scene. We are too big to fail. But you don’t have to delve far into the history books to see what has happened to other once-dominant powers. Most of us have witnessed seismic political shifts in our lifetime. In 1985, Mikhail Gorbachev settled into his job as the Soviet Union’s young and charismatic new leader and began acting on his mandate to reenergize the socialist empire. Seven years later that empire collapsed and disappeared from the face of the Earth. Gorbachev runs a think tank in Moscow now.
In a sense, the larger world is starting to resemble the nasty and brutish life that long has characterized the corporate world. Just ask Jeffrey Immelt, chairman and CEO of General Electric. Of the twelve giants that made up the first Dow Jones Industrial Average in 1896 – all of them once considered too big to fail – only GE remains. The other towering names of the era – the American Cotton Oil Company, the US Leather Company, the Chicago Gas Company, and the like – all have faded away. And as GE stands against the winds of today’s financial challenges, ask Immelt whether there is such thing as a company that is too big to fail.
I love to read history books for the lessons they offer. After all, as the homily goes, if you don’t learn from history, you may be doomed to repeat it. Great powers rise and fall. None has a covenant to perpetuate itself without cost. The millennium of the Roman Empire – which included five hundred years as a republic – came to an end in the fifth century after scores of years of gradual decay. We Americans often study that Roman endgame with trepidation. We ask, as Cullen Murphy put it in the title of his provocative 2007 book, are we Rome?
The trouble is not that we see ourselves as an empire with global swagger. But we do see ourselves as a superpower with global responsibilities – guardians if not enforcers of a Pax Americana. And as a global power, America presents unsettling parallels with the disintegration of Rome – a decline of moral values, a loss of political civility, an overextended military, an inability to control national borders, and a growth of fiscal irresponsibility by the central government. Do these sound familiar?
Finally, there is what Murphy calls the “complexity parallel”: Mighty powers like America and Rome grow so big and sprawling that they become impossible to manage. In comparing the two, he writes, one should “think less about the ability of a superpower to influence everything on earth, and more about how everything on earth affects a superpower.”
A superpower that is financially reliant on others can be vulnerable to foreign influence. The British Empire learned this in 1956, when Britain and France were contesting control of the Suez Canal with Egypt. The Soviet Union was threatening to intervene on Egypt’s side, turning the regional dispute into a global showdown between Moscow and Washington. The Eisenhower administration wanted to avoid that, and the United States also happened to control the bulk of Britain’s foreign debt. President Eisenhower demanded that the British and French withdraw. When they refused, the United States quietly threatened to sell off a significant amount of its holdings in the British pound, which would have effectively destroyed Britain’s currency. The British and French backed down and withdrew from Suez within weeks.
The US dollar has never come under a direct foreign attack (though its vulnerability is growing). A direct foreign attack would result in a dramatic move away from the dollar. That would lead to a significant decline in its value, as well as higher interest rates. This is often referred to by economists as a “hard landing.” In lay terms, it’s more like a crash landing. Still, Americans have become intimately acquainted with the shocks of financial instability. Americans of a certain age still vividly recall the depths of the Depression in the 1930s and the chaos of inflation and long gasoline lines during the oil shock of the 1970s.
We will also remember the financial collapse that began in 2008, and we pray for nothing worse. Some of our smartest financial thinkers are praying right along with us. “I do think that piling up more and more and more external debt and having the rest of the world own more and more of the United States may create real political instability down the line,” investor Warren Buffett has said, “and increases the possibility that demagogues [will] come along and do some very foolish things.”
Ken Lewis' A-List Witness List
by Charlie Gasparino
In defending former Bank of America CEO Ken Lewis against charges that he misled investors, his lawyers will call as witnesses former Treasury Secretary Hank Paulson and the current Federal Reserve Chairman Ben Bernanke, according to people close to the matter. The defense team, led by former U.S. Attorney Mary Jo White, hopes to get Paulson and Bernanke to reveal that Lewis did not mislead the government about BofA's deteriorating financial condition in the aftermath of its Merrill Lynch deal. Those losses prompted a massive government bailout.
White's first order of business is to get the civil case dismissed, according to several sources. But if she's unsuccessful, she plans a vigorous defense, including calling high-level government officials to testify. "If this thing goes to trial you can expect both Paulson and Bernanke to be on the witness list," said one person close to the defense team, "and right now Lewis doesn't want to settle."
It is unclear if either Bernanke or Paulson have already given testimony to the state attorney general in preparation for bringing today's case, which includes civil fraud charges against former Bank of America CFO Joe Price. (A spokesman for Cuomo's office did not return a call for comment; a spokesman for Bernanke had no comment and a spokeswoman for Paulson didn't return an email request for comment. And a spokesman for Lewis declined to comment on the matter.) So far, both men have given testimony before Congressional committees on the controversial merger. Paulson addresses the matter in On the Brink, his new book about his role in the financial meltdown of late 2008.
In a statement, White said that Lewis is being "publicly vilified by the political search for accountability for the financial meltdown." White also said that despite the initial problems with the merger—including the mounting losses that led to the government bailout—the merger has turned out to be an "unmitigated success for BofA." Merrill Lynch trading operations, like the trading operations of the other big banks, have taken advantage of historically low interest rates and borrowing costs to earn billions of dollars in profits, helping the banks to smooth out losses from consumer and commercial real-estate loans that continue to mount as economic conditions remain weak.
Bank of America's ill-fated purchase of Merrill in the middle of the 2008 financial meltdown has become the focal point of both congressional inquiries, a separate probe by the Securities and Exchange Commission (BofA also agreed to pay $150 million today to settle separate SEC charges) and the case brought today by the New York State Attorney General's office. When Lewis agreed to pay around $50 billion for Merrill Lynch the weekend that Lehman Brothers declared bankruptcy in fall 2008, he was considered a hero at first—both by regulators and also Bank of America shareholders who assumed Merrill’s losses were manageable, particularly given BofA's large balance sheet.
But in the ensuing weeks, those losses looked more and more toxic, and after BofA shareholders approved the deal in early December 2008, Lewis told Bernanke and Paulson that he wanted to back out of the deal because Merrill's losses were so large that they imperiled BofA's future. Since the matter became public, Lewis has been under fire over what he knew about Merrill's losses—as well as when he knew it. As I first reported back n last year when I broke the story that Lewis resigned, people close to him said the move resulted from the mounting pressure, from regulators and shareholders about his role in disclosing key details about the Merrill deal. In the New York Attorney General’s civil case, Cuomo alleges that Lewis knew Merrill's losses were huge before the shareholder vote and should have disclosed them before they voted to approve the deal, which caused BofA's stock to crater.
Lewis contends that he didn't disclose the mounting losses on the advice of company attorneys. There is also the matter of the controversial government bailout— namely was Lewis truthful when he approached Bernanke and Paulson in mid December that he wanted to back out of the Merrill deal, unless the government provided massive assistance. Cuomo says in his civil suit Lewis was not truthful, but according to people close to Lewis' legal team, both Bernanke and Paulson will be called to testify that he was.
Wall Street's Killer Instinct Spells Death Knell for Jobs
by Pam Martens
I think it’s time to take Wall Street literally: they’ve made it abundantly clear they have an insatiable appetite for killing things: the housing market, the financial system, the economy, reform legislation, the next generation’s future. Wall Street is so steeped in destruction that the symbols of death are everywhere. Wall Street calls the big newspaper ads they take out to herald the launch of their market offerings a “tombstone.” (To understand how appropriate that is, consider the billions in bond and stock offerings they raise for Big Tobacco.) What does Wall Street call the completion of a buy or sell order: an “execution.” (Think of how many derivative trades they “executed” for the now crippled, life support patients Fannie Mae, Freddie Mac and AIG; or the off balance sheet vehicles they created for Enron, WorldCom, and dozens of now bankrupt companies.)
Wall Street calls an order to complete a trade without any reduction in quantity a “fill or kill.” This could just as reasonably be called a “fill or cancel” order but it’s so much more fun for the thundering herd to race around a trading floor screaming “kill it, kill it!” What is the benefit to Wall Street in killing things or bringing the share price of companies to near worthless? Tails they win; heads you lose. Wall Street can and does make enormous profits on bets that share prices will decline (shorting), that companies will disappear (credit default swaps), that the economy will crater (interest rate swaps). And there’s a slogan on Wall Street: the trend is your friend. When it’s clear the bull is lying in the center of the ring (think Lehman’s death and the Merrill Lynch shotgun wedding on September 15, 2008), Wall Street moves its bets to the downside.
No one has their jive aligned with their agenda any better than Citigroup’s traders. When they set out to inflict pain on the European bond market in 2004, they labeled the trade “Dr. Evil.” Citi also created a structured finance vehicle that greased the skids for the collapse of Italian dairy giant Parmalat, dubbed Buconero, Italian for “Black Hole.” Until a President comes along with a genuine will to deal with the truly rapacious nature of Wall Street, these destructive forces will continue.
President Obama’s latest Wall Street reform plan to bar commercial banks from owning private equity funds or hedge funds and banning proprietary trading for the benefit of their own firm constitutes needed reform toward unrigging the markets. But the proposal neglects Wall Street’s most serious threat to the economy. It’s the commercial banks’ ownership of investment banks and brokerage firms that’s killing innovation and job growth in America. The longer we wait to deal with this issue, the more the national debt will balloon as the government is forced to indefinitely add job stimulus money and sustenance funds for the growing number of unemployed.
As currently structured, Wall Street investment banks have no incentive to bring viable companies to market. Wall Street makes the same huge fees for putting lipstick on a pig and dumping it on the public as they do for launching solid companies with real job growth potential. Over the past decade, trillions of dollars of investors’ life savings have been misallocated to bogus business models. Those companies are now worthless or are trading for pennies on the Pink Sheets, the graveyard for investment banks’ misfired ideas.
The Pink Sheets provide quotes on these stocks to broker dealers. It’s not responsible for the legitimacy of the companies and, in fact, warns investors on its web site that these “are small companies with limited operating histories or are economically distressed…Investors should avoid the OTC [over the counter] market unless they can afford a complete loss of their investment.” In many cases, this is far more disclosure than licensed brokers at the “venerable” firms told their clients when the companies first went public at fat share prices.
A study done by Tyler Shumway and Vincent A. Warther for the University of Michigan Business School and University of Chicago Graduate School of Business found that between 1972 through 1995, 4,188 companies were delisted by Nasdaq, the stock exchange that facilitated the boom and bust in dotcoms and tech start ups in the late 90s. After delisting, many ended up on the Pink Sheets. In March 2000, the Nasdaq index stood at 5,048. Today, a decade later, it’s still down 58 percent from its peak.
It's time for Congress to open its eyes to the reality that this massive decline in Nasdaq is telling us Wall Street is not bringing enough good companies to market. And the mergers Wall Street has put together, typically traded on the New York Stock Exchange, have created Frankenbanks and debt-laden conglomerates too bloated to figure out their own balance sheet let alone create new jobs. Two poster children come to mind: AOL-TimeWarner and Citibank-Travelers-Smith Barney-Salomon, a/k/a Citigroup.
Investment banks that arrange these initial public offerings of new companies or merge together existing ones are now located within the “too big to fail,” publicly traded commercial banks. But they used to be private partnerships and put their own money at risk when bringing a new company to market. When their own money was at risk, there was a far greater due diligence done to ensure the company would be viable. That’s gone now. There’s no incentive to be vigilant. It’s OPM: other people’s money to throw down on the casino table. To fully understand the new structure of Wall Street, it helps to reflect back to August 1995 when the FDA told us that a cigarette was really a nicotine delivery system in drag and Big Tobacco was manipulating “nicotine delivery at each stage of production.” People were being hooked on something very harmful to their well being while a colluding industry lied and lobbied.
Insiders on Wall Street call their retail brokerage firms, now also dangerously merged with commercial banks, a “distribution” system. The investment banks create the toxic product, the brokers distribute it to the public under an enshrined carrot and stick system that is virtually identical at every major firm. That is, the internal research department puts out a buy recommendation. The brokers’ local manager holds a sales meeting and pushes the firm’s latest offerings. The brokers’ commission system dramatically favors risky products that the firm is pumping out over safer investments. There is absolutely no system that rewards a broker for how well his clients’ portfolio performs. The broker’s ability to have secretarial help, the size of his or her office, gaining the title of Vice President on the business card, the annual bonus, even being taken out to lunch by the Branch Manager, is dependent solely on how much money the broker makes for the firm.
If you want to challenge the system as corrupt, the courthouse doors are closed to you. Wall Street enforces its own private justice system called mandatory arbitration. The public is not allowed to have a peek, after all it’s private justice, so there is no disinfecting sunshine on this cabal. The only way a system this riddled with conflicts of interest and contempt toward its own customers' interests could have survived this long was by grabbing that huge depositor base of money from the commercial banks and then trading it into oblivion. The newest patsy in this grand bank heist is the taxpayer who is replenishing the empty vaults.
With each new $100 billion job creation program from the government, we acknowledge that Wall Street isn't creating companies that create jobs. According to the Labor Department, 9.3 million Americans could not find work as of January and millions more are involuntarily working part-time or too discouraged to look for work. So if Wall Street is not properly allocating capital to viable companies, it’s not rewarding its shareholders or customers, remind me again why taxpayers are spending trillions to save it?
The February 15, 1999 cover of Time magazine lauded Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and Deputy Treasury Secretary Lawrence Summers as The Committee to Save the World. We now know this was really The Committee to Slave the World. The economic challenges the world now confronts were of their making; together, of course, with some well placed Washington and Wall Street cronies.
Greenspan has a B.S., M.A. and Ph.D. in Economics from New York University; Rubin has a B.A. in Economics from Harvard and a law degree from Yale. Summers has a B.S. from M.I.T. and a Ph.D. from Harvard. Despite these 7 degrees from some of the finest institutions of learning in the country, we are asked to believe that there was not one ounce of common sense that suggested to these men that repealing the depression era investor protection legislation known as the Glass-Steagall Act that prevented the combination of commercial banks with investment banks and brokerage firms would end up killing jobs, the financial system and the economy. (Were we not looking at men who profited greatly from that bad decision, we might be less skeptical.)
There has been this intellectual dishonesty and revisionist history suggesting no one could have seen this coming. Not only did lots of people see it coming but on June 25 and June 26, 1998 a steady stream of public-minded citizens walked through the stately doors of the Federal Reserve Bank of New York and testified that repealing the Glass-Steagall Act and allowing commercial banks to merge with Wall Street firms was a preposterously bad idea and would lead to economic ruin. Why is our President turning to Summers and Rubin for advice instead of the people who got it right?
President Obama has now anointed Neal Wolin to join the New Committee to Save the World along with himself and former Fed Chair Paul Volcker. Who is Neal Wolin? He was confirmed as Deputy Secretary of the Treasury on May 19, 2009. In the Clinton administration, Wolin was general counsel to Lawrence Summers, a key proponent of repealing the Glass-Steagall Act. According to the New York Times, Mr. Summers earned $5.2 million in 2008 working one day a week for the hedge fund, D.E. Shaw & Company, while simultaneously advising Obama. After leaving government, Wolin worked for Hartford Financial Services Group Inc. for eight years. According to BusinessWeek, if you add up Wolin’s cash compensation, restricted stock awards, options, and other compensation, he made $3.4 million his last year at Hartford in 2008.
Robert Scheer wrote the following about Wolin at the San Francisco Chronicle on November 19, 2009:“Wolin, Geithner and Summers were all proteges of Robert Rubin, who, as Clinton's treasury secretary, was the grand author of the strategy of freeing Wall Street firms from their Depression-era constraints. It was Wolin who, at Rubin's behest, became a key force in drafting the Gramm-Leach-Bliley Act, which ended the barrier between investment and commercial banks and insurance companies, thus permitting the new financial behemoths to become too big to fail. Two stunning examples of such giants that had to be rescued with public funds are Citigroup bank, where Rubin went to ‘earn’ $120 million after leaving the Clinton White House, and the Hartford Insurance Co., where Wolin landed after he left Treasury.”
Mr. President, it’s time to clear out the fat cats and deliver on that message of hope and change.
New Mexico House Votes 65-0 To Move State's Money To Credit Unions, Community Banks
New Mexico's House of Representatives voted Monday to pass a bill that allows the state to move $2 billion - $5 billion of state funds to credit unions and small banks. The municipal funds bill was approved 65-0 (roll call - PDF), and is subject to a vote by New Mexico's Senate. Governor Bill Richardson told the bill's sponsor that he supports the legislation. Credit Union Times, spoke to one banker who believes that the bill got a boost from Huffington Post's Move Your Money campaign:The altered view of New Mexico lawmakers in favoring local control of state funds, officials said, follows national mention of the New Mexico effort in the "Move Your Money" campaign of New York pundit Arianna Huffington in her online Huffington Post columns. "I think Huffington gave this bill a little traction," said Juan Fernandez, vice president of government affairs for the Credit Union Association of New Mexico.
Move Your Money is a project started by Arianna and Rob Johnson that aims to spur financial reform at big banks by encouraging account holders to move their money to smaller credit unions and community banks. New Mexico currently keeps $1.4 billion in accounts at Bank of America. New Mexico State Representatives Brian Egolf (D-Santa Fe) and Timothy Keller (D-Bernalillo) sponsored the bill, HB 66. Rep. Eglof told the Huffington Post in January that the legislation 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.'"
The Growing Problem in Agriculture Markets
A government report last month of record crops startled agriculture markets. Tuesday could bring the first in a series of aftershocks. Corn prices have plummeted 16% and soybeans by 7% since the Department of Agriculture said Jan. 12 that American farmers produced more of each than ever before. Many observers expected a lower forecast because they thought the crop would suffer due to bad weather, but instead the market faced a surprise glut. There may be more on the way. The USDA is due to release its estimate of world supply and demand Tuesday morning. Analysts already anticipate a bumper crop from Argentina and Brazil, including at least 65 million tons of soybeans from Brazil. That would be about 14% larger than the prior year's production.
If the latest number is even larger than expected, that could deepen or prolong the recent price drops. If it is on the lower end, "the markets could react with a bounce," said Terry Roggensack, an agriculture specialist at the Hightower Report in Chicago. (The report also marks the first official reading on orange-crop losses after freezing Florida temperatures last month.) Even absent new shocks Tuesday, there is more potential turmoil ahead. When it issued the surprising report, the Agriculture Department also said there was "significant unharvested acreage" of both crops. It pledged to resurvey farmers to see what they were able to harvest amid wintry weather. The unusual update is due March 10, and it has caused "a greater level of uncertainty" about the January report, said Richard Feltes, an analyst at MF Global.
On March 31, the market may get a sense of how U.S. farmers are reacting to the glut and the price drops, when the USDA says how many acres it expects them to devote to various crops this spring. That is a roadmap to what growers think they can produce profitably, and could therefore hint at the glut's staying power. All this takes place against the backdrop of booming global population and rapid growth in the developing world, which are creating great change on farms world-wide that feed those more numerous and increasingly prosperous mouths. The recent crop sizes and price moves show agricultural markets adjusting to the changing terrain.
40%-50% Chance Stocks Will Crash To New Low, Says Gary Shilling
Last summer, our guest Gary Shilling of A. Gary Shilling & Co. predicted that stocks would fall 30%. That hasn't happened yet, but the extraordinary bull run that made idiots out of many of Wall Street's greatest gurus last year has now finally reversed, and Gary is sticking by his bearish guns. At Dow 10,000, Gary says, stocks are still priced to reflect a strong economic recovery throughout 2010 and 2011. And that's not going to happen. Consumers still account for more than 70% of the spending in the U.S. economy, and consumers are retrenching. The value of their assets has plummeted, so they're finally saving again. They're unemployed. They're tapped out. Put all that together, and consumer spending will continue to be weak, and the overall economy will only grow 2% a year.
When the market finally realizes that its dream of a v-shaped recovery is too optimistic, stocks will go lower--perhaps much lower. In fact, Gary thinks there's a 40%-50% chance they'll crash right through the bear-market lows set last spring. So what's an investor to do? Buy Treasury bonds, Gary says. Contrary to the concerns of they hyper-inflation crowd, the world is awash in excess capacity. We have too much production capacity, too many houses, too much labor. Overcapacity leads to deflation, not inflation. So today's 4.5% long-term Treasury yield will go to 3%, making bondholders 25% in the process.
And buy the dollar. At the end of last year, everyone agreed that the dollar was going to continue to collapse. That was your queue to get the heck out. It's not that we don't have serious problems with deficits and debt in the U.S., Gary says--it's that our problems are less bad than the problems facing the Euro. Gary thinks the dollar will rise back to parity with the Euro, a major move from the ~$1.35 it takes to buy a Euro today. And sell commodities. China is overheating, and as it corrects, it will take global commodity demand down with it. In short, Gary says, do exactly the opposite of what everyone was telling you to do at the end of last year.
Vietnam as Asia's first domino
by Shawn W. Crispin
While global markets fret about European sovereign debts, could Vietnam be Asia's first over-stimulated economic domino? With a wobbly currency, fast and loose bank lending and an absence of local confidence in the government's economic management, Vietnam stands out as the region's prime candidate for a sudden market re-evaluation of the financial impact of recently ramped and frequently misallocated fiscal spending. On the back of massive government pump-priming, Vietnam last year outperformed several of its regional peers with 5.5% gross domestic product (GDP) growth. To counteract the global economic downturn, the government pledged economic stimulus packages amounting to a whopping 8% of GDP. Although less than half of that amount has actually been disbursed, on-budget spending and off-budget state bank lending propelled the economy through the global crisis.
With emerging signs of global recovery, the communist party-led government has signaled its intention to rein in the stimulus and return the economy to export-oriented growth. But a lack of policy coordination across state agencies and enterprises has further eroded local confidence in the government's ability to control future inflation and to a significant degree has undermined central efforts to contain pressures on the currency and an overheating property market.
The disconnect between central command and peripheral resistance was made apparent last year when many export-oriented industries refused to cash in their export receipts at the official exchange rate for the dong against the US dollar. As of October, there was a 9% spread between the official and black market rates, and that gap drove the government's decision in November to devalue the dong by 5% by expanding its permissible trading band. Even with that depreciation, financial analysts monitoring the situation say there is still a 5% spread between the official and black market rates.
One factor driving the distortion is the government's interest rate subsidies, which were implemented last year as part of the stimulus package to encourage more local lending. The policy effectively reduced lending rates from 10% to 6.5% and drove huge new lending worth around $24 billion, or nearly 23% of GDP. According to Standard & Poor's, a credit rating agency, Vietnam's year-on-year loan growth was up 37%. Financial analysts say that because there was virtually no underlying demand for working capital among state-owned enterprises (SOEs) and export-oriented private companies that received the bulk of the new credits, much of the money was recycled into the local stock market. The footloose liquidity contributed to making Vietnam's stock market one of the world's best performers during the first half of 2009; it then fell dramatically in the second half.
It's unclear to financial and sovereign analysts how much of last year's US$24 billion in new lending was lost to stock market speculation. Kim Eng Tan, a sovereign and public finance analyst at Standard & Poor's, expressed his preliminary concerns about last year's 37% loan growth rate. He said that the balance sheets of major Vietnamese banks were in "reasonable shape" at the end of 2008, but that "we'll need to see what has changed after the new surge in lending". From the government's perspective, the easy money aimed to forestall a spike in unemployment at a time when labor-intensive export industries faced a near collapse in global trade. The Communist Party leadership clearly wanted to avoid a repeat of the social instability witnessed in 2008 when inflation topped out at over 25% and labor unrest spread in both foreign and locally owned factories across the country.
Galloping inflation also contributed to a ballooning current account deficit as companies built up large inventories of imports to arbitrage anticipated higher prices and demand. The loss of economic control is known to have undermined the position of liberalizing Prime Minister Nguyen Tan Dung, whom some analysts estimate was only spared full-blown hyperinflation by the global economic downturn and its associated commodity price collapse. Some analysts believe that party conservatives could regain the upper hand at the 11th National Party Congress scheduled for January 2011.
Carlyle Thayer, a Vietnam expert at the Australian Defense Force Academy, points to reports that party conservatives had called for Dung's resignation at a central committee meeting in 2008 over his perceived mishandling of the economy. The main policy divide between party conservatives and liberalizers concerns the pace and scope of Vietnam's integration with the global economy and its impact on domestic stability and state control over the economy, according to Thayer. "Conservatives seek to preserve one-party rule, maintain order and stability and state control over key sectors of the economy, which they regard as their 'milk cows'," Thayer wrote in e-mail correspondence with Asia Times Online. "It is clear that reform of state-owned enterprises has stalled, for example. Those [like Dung] pushing for increased global integration would like to see market forces play a greater role."
While Dung's broad economic and financial liberalization program is still on track, there are signs that conservative elements are asserting more influence over economic management. The State Bank of Vietnam (SBV) has required that small banks, which contributed to inflation through rampant lending in 2008, triple their underlying capital by year's end or face closure. The government has also ordered closed gold exchanges across the country - a restriction that will come into full force in March in a bid to stop local dumping of dong for gold.
Pressures and distortions
New technocratic tests are emerging with signs of inflation, a rising trade deficit and sustained downward pressure on the dong vis-a-vis a globally weak US dollar. Even with last November's 5% devaluation of the dong and a hike in baseline interest rates from 10% to 12%, state-owned enterprises and private companies continue to hoard dollars over dong, underscoring the lack of local confidence in the SBV's ability or willingness to check inflation. "The central bank needs to send a fairly stiff signal to the market that it is willing to defend the currency band, most likely by raising interest rates further," said Sriyan Pietersz, head of research at J P Morgan in Bangkok. "Without that, they risk losing potential FDI [foreign direct investment] inflows due to a shaky currency."
A $1 billion dollar-denominated bond issue was fully subscribed by foreign investors in January but analysts say that's not enough to alleviate the new pressures building around the dong. The currency should get a short reprieve from Tet holiday-related remittance inflows this month, but many analysts believe the SBV needs to raise interest rates by at least another 3% to put a punitive local tax on those who convert dong to dollars. As the SBV is the only official source of foreign exchange inside the country, the government maintains strict capital controls in defense of the dong. By law, companies and enterprises are allowed to hold only enough foreign exchange to pay debts and settle current trade transactions. Yet as of the third quarter of last year, 27% of all liquidity in the local financial system had fled dong for dollars, according to J P Morgan.
Despite the currency controls, SOEs are estimated to hold around $10 billion worth of mainly dollar-denominated foreign exchange. Notably, they have recently defied a government-issued circular decree addressed specifically to 10 large SOEs, including Vietnam Oil and Gas Group, Vietnam National Coal and Mineral Group and Vietnam National Chemical Corporation, requiring them to cash in their dollars for dong. According to the circular, SOEs were to have turned over $3 billion of their foreign holdings to the SBV by the end of last year; as of early February, they had only released $300 million, according to analysts tracking the situation. The defiance, the same analysts say, has contributed to the SBV's reluctance to inject more liquidity into the market to defend the currency. According to official statistics the SBV currently holds around $16 billion worth of foreign reserves.
While Vietnam clearly cribbed from China's extraordinary fiscal response to the global economic downturn, Hanoi comparatively lacks the top-down controls that have allowed Beijing to put a more authoritative brake on its stimulus. As the recent tug-of-war over foreign exchange indicates, Vietnam's big SOEs are still often run as the personal fiefdoms of politically powerful Communist Party members with enough clout to defy central directives. Some analysts contend it is reassuring that Vietnam's perennial loss-making SOEs are finally prioritizing profitability over state policy. To others, it underscores the sustained lack of transparency and accountability of big SOEs and raises worrying new questions about how the billions of dollars worth of bank loans they received last year were put to use. State-motivated lending that was last year funneled into stock market speculation now appears to be fast pumping up property prices, particularly in Ho Chi Minh City.
What's clearer is that Vietnam still lacks effective policy coordination across state agencies and enterprises at a time economic authorities need to show the market a renewed commitment to maintaining macroeconomic and price stability. The lack of control also resurrects questions lingering about the central bank's patchy handling of 2008's inflationary surge and its technocratic capacity to head off new emerging inflationary pressures, including in the property market. J P Morgan's Pietersz says the relevant authorities are "very bright and committed", but still "learning by doing" in managing the economy. Others say it is not clear that the internally divided government has the political will to roll back last year's stimulus measures in the politicized run-up to next year's National Party Congress.
"Ultimately, the government can't close down the whole economy ... but inflation expectations will have to be anchored somehow," said Tan of Standard & Poor's. "If inflation is kept high for a long time, it could be a serious vulnerability." A research analyst with a European investment bank estimates that Vietnam's "day of reckoning" is "inevitable due to the government's inability to raise revenues" and that the country will face more "convulsive devaluations" until the central bank is allowed more independence from party heavies. Despite the recent pressure on the dong, Tan says Vietnam does not exhibit symptoms of a "classic currency crisis" because "external borrowing is still largely under control" and "FDI has held up well". Unlike in the debt-binged countries hit by the 1997-98 Asian financial crisis, he notes, Vietnam's debt burden is comparatively modest because it is wrapped up largely in low-risk, long-term concessionary loans.
But as market scrutiny over public finances intensifies in Europe, country-by-country risk in Asia will increasingly be determined by investor perceptions of how governments have managed and spent recently ramped fiscal measures. Locals in Vietnam have already made clear their mistrust of the government's management and history shows foreign sentiment often lags but eventually follows indigenous leads in high-risk emerging markets. As fears of state-led financial contagion rise in Europe, Vietnam seems the leading candidate for a parallel crisis of confidence in Asia.
China PLA officers urge economic punch against U.S.
Senior Chinese military officers have proposed that their country boost defense spending, adjust PLA deployments, and possibly sell some U.S. bonds to punish Washington for its latest round of arms sales to Taiwan. The calls for broad retaliation over the planned U.S. weapons sales to the disputed island came from officers at China's National Defence University and Academy of Military Sciences, interviewed by Outlook Weekly, a Chinese-language magazine published by the official Xinhua news agency. The interviews with Major Generals Zhu Chenghu and Luo Yuan and Senior Colonel Ke Chunqiao appeared in the issue published on Monday.
The People's Liberation Army (PLA) plays no role in setting policy for China's foreign exchange holdings. Officials in charge of that area have given no sign of any moves to sell U.S. Treasury bonds over the weapons sales, a move that could alarm markets and damage the value of China's own holdings. While far from representing fixed government policy, the open demands for retaliation by the PLA officers underscored the domestic pressures on Beijing to deliver on its threats to punish the Obama administration over the arms sales.
"Our retaliation should not be restricted to merely military matters, and we should adopt a strategic package of counter-punches covering politics, military affairs, diplomacy and economics to treat both the symptoms and root cause of this disease," said Luo Yuan, a researcher at the Academy of Military Sciences. "Just like two people rowing a boat, if the United States first throws the strokes into chaos, then so must we." Luo said Beijing could "attack by oblique means and stealthy feints" to make its point in Washington. "For example, we could sanction them using economic means, such as dumping some U.S. government bonds," Luo said.
The warnings from the PLA come after weeks of strains between Washington and Beijing, who have also been at odds over Internet controls and hacking, trade and currency quarrels, and President Barack Obama's planned meeting with the Dalai Lama, the exiled Tibetan leader reviled by China as a "separatist." Chinese has blasted the United States over the planned $6.4 billion arms package for Taiwan unveiled in late January, saying it will sanction U.S. firms that sell weapons to the self-ruled island that Beijing considers a breakaway province of China.
China is likely to unveil its official military budget for 2010 next month, when the Communist Party-controlled national parliament meets for its annual session. The PLA officers suggested that budget should mirror China's ire toward Washington. "Clearly propose that due to the threat in the Taiwan Sea, we are increasing military spending," said Luo. Last year, the government set the official military budget at 480.7 billion yuan ($70.4 billion), a 14.9 percent rise on the one in 2008, continuing a nearly unbroken succession of double-digit increases over more than two decades.
The fresh U.S. arms sales threatened Chinese military installations on the mainland coast facing Taiwan, and "this gives us no choice but to increase defense spending and adjust (military) deployments," said Zhu Chenghu, a major general at China's National Defence University in Beijing. In 2005, Zhu stirred controversy by suggesting China could use nuclear weapons if the United States intervened militarily in a conflict over Taiwan. The United States switched official recognition from Taiwan to China in 1979. But the Taiwan Relations Act, passed the same year, guarantees Taiwan a continued supply of defensive weapons.
China has the world's biggest pile of foreign currency reserves, much of it held in U.S. treasury debt. China held $798.9 billion in U.S. Treasuries at end-October. But any attempt to use that stake against Washington would probably maul the value of China's own dollar-denominated assets. China has condemned previous arms sales, but has taken little action in response to them. But Luo said the country's growing strength meant that time has passed. "China's attitude and actions over U.S. weapons sales to Taiwan will be increasingly tough," the magazine cited him as saying. "That is inevitable with rising national strength."
The Dumping Begins: Chinese Reserve Managers Notified That Any Non-USG Guaranteed Securities Must Be Divested
by Tyler Durden
It appears that this time China's posturing is for real. Following up on our earlier post that Chinese military officials want to "punish" America by selling Treasuries, Asia Times Online is reporting that an explicit directive by the Chinese government has notified reserve managers to sell all risky US assets, including asset backed and corporates, and just hold on to explicitly guaranteed Treasuries and Agency debt. And from following TIC data we know that China's enthusiasm for MBS/Agencies over the past year has been matched solely by that of one Bill Gross.
From Asia Times:
Dollar-denominated risk assets, including asset-backed securities and corporates, are no longer wanted at the State Administration of Foreign Exchange (SAFE), nor at China’s large commercial banks. The Chinese government has ordered its reserve managers to divest itself of riskier securities and hold only Treasuries and US agency debt with an implicit or explicit government guarantee. This already has been communicated to American securities dealers, according to market participants with direct knowledge of the events.
It is not clear whether China’s motive is simple risk aversion in the wake of a sharp widening of corporate and mortgage spreads during the past two weeks, or whether there also is a political dimension. With the expected termination of the Federal Reserve’s special facility to purchase mortgage-backed securities next month, some asset-backed spreads already have blown out, and the Chinese institutions may simply be trying to get out of the way of a widening. There is some speculation that China’s action has to do with the recent deterioration of US-Chinese relations over arm sales to Taiwan and other issues. That would be an unusual action for the Chinese to take–Beijing does not mix investment and strategic policy–and would be hard to substantiate in any event.
Furthermore, demonstrating just how seriously China is approaching a populist-driven adversarial stance with the US, was earlier speculation that instead of unpegging its currency (a move much desired by the US administration in its goal to further weaken the dollar and make China less competitive in the export market), China would reduce its trade balance not by the traditional way of currency inflation, but by the economic textbook footnote approach of raising salaries.
Higher labor costs would cut Chinese export competitiveness while boosting domestic spending power and sustaining economic growth, according to the bank. Premier Wen Jiabao’s government has been pressed by U.S. and European officials to end a 19- month yuan peg to the dollar to help diminish trade and investment imbalances that contributed to the credit crisis.
“Wage increases are a better option because they largely benefit Chinese workers,” Tao Dong, a Credit Suisse economist in Hong Kong who has covered the Chinese and Asian economies for more than 15 years, said in an interview yesterday. “Currency appreciation will only result in Chinese exporters losing out to competitors in countries such as Malaysia and Mexico.”
The strategy may limit gains in the yuan to 3 percent this year, according to Tao. This month’s 13 percent increase in minimum wage in eastern China’s Jiangsu province indicates that higher pay will play an important role in officials’ efforts to rebalance growth in the fastest-growing major economy, Tao said.
The wage decision “argues against a large one-off yuan revaluation,” Ben Simpfendorfer, an economist with Royal Bank of Scotland in Hong Kong, wrote in a note this week.
One thing is certain - China will now focus on doing precisely the opposite of what America would urge Chinese authorities to do, in order to establish itself as the focal point of negotiating leverage and increasingly humiliate the Obama regime. If this involves selling USTs or corporates (both fixed income and equities) so be it. This is further confirmed by carefully worded disclosure in today's copy of China Securities Journal:
The China Securities Journal, a government-backed daily, accused the U.S. in a tough-worded front page editorial of playing the "exchange rate card."
It said that, just as China didn't interfere with Federal Reserve purchases of U.S. Treasuries, "the U.S. has no right to interfere in China's exchange rate policy."
"Whether or not to appreciate is our own business," the newspaper said.
"Whether it will appreciate, when and by how much is an integral part of China's monetary policy."
It is not clear when the asset divestiture directive takes place or if it is already being enforced. Juding by the afterhours action in futures and the currency markets, some dumping may already be taking place. Alternatively, we now know just who it is that sell into every rally (yes, even in this market, every buyer is matched with a seller).
Fannie and Freddie Stagger On as Troubled Wards of the State
When Charles E. Haldeman Jr. became Freddie Mac's chief executive officer in August, the ailing housing-finance giant had already consumed $51 billion of government money to stay afloat. It's likely to need even more. Freddie's federal overseers nevertheless have instructed Mr. Haldeman to focus on something that isn't likely to make the bleak balance sheet look any better: carrying out the Obama administration plan to allow defaulted borrowers to hang onto their homes.
On a recent afternoon, employees at Freddie's headquarters here peppered Mr. Haldeman with concerns about the company's future. He responded that they were "fortunate" to have such a clear mission—the government's foreclosure-prevention drive. "We're doing what's best for the country," he told them. Freddie and its larger rival, Fannie Mae, were among the first big financial institutions to receive massive federal bailouts after the financial crisis hit in 2008. Government officials have been racing to fix bailed-out car makers and banks and are pushing to reshape the financial-services industry. But Fannie and Freddie remain troubled wards of the state, with no blueprints for the future and no clear exit strategy for the government.
Nearly a year and a half after the outbreak of the global economic crisis, many of the problems that contributed to it haven't yet been tamed. The U.S. has no system in place to tackle a failure of its largest financial institutions. Derivatives contracts of the kind that crippled American International Group Inc. still trade in the shadows. And investors remain heavily reliant on the same credit-ratings firms that gave AAA ratings to lousy mortgage securities. Fannie and Freddie, for their part, remain at the core of a housing-finance system that inflated a dangerous housing bubble. After prices collapsed, sending shock waves around the world, the federal government put America's housing-finance system on life support. It has yet to decide how that troubled system should be rebuilt.
On Dec. 24, Treasury said there would be no limit to the taxpayer money it was willing to deploy over the next three years to keep the two companies afloat, doing away with the previous limit of $200 billion per company. So far, the government has handed the two companies a total of about $111 billion. The government is willing to tolerate such open-ended exposure for two reasons.
First, it sees the companies as essential cogs in the fragile housing market. Fannie and Freddie buy mortgages originated by others, holding some as investments and repackaging others for sale to investors as securities. Together with the Federal Housing Administration, they fund nine in 10 American mortgages. Worries about potential insolvency would cripple their ability to fund home loans, which would hamstring the market.
Second, the companies are a convenient tool for the administration to use in its campaign to clean up the housing mess. "We're making decisions on [loan modifications] and other issues, without being guided solely by profitability, that no purely private bank ever could," Mr. Haldeman said in late January in a speech to the Detroit Economic Club.
Besides playing a key role in the loan-modification program, Fannie and Freddie have jump-started lending by state and local housing-finance agencies by helping to guarantee $24 billion in debt. They also are lending support to the apartment sector by becoming the main funders of loans to builders and buyers of apartment buildings. By using Fannie and Freddie for such initiatives, the White House doesn't have to go to Congress for funding. The Treasury and White House can simply issue instructions to Fannie and Freddie via their federal regulator, the Federal Housing Finance Agency, or FHFA.
The government is "running Fannie and Freddie as an instrument of national economic policy, not as a business," says Daniel Mudd, who was forced out as Fannie Mae's chief executive in September 2008 when the government took control. Assistant Treasury Secretary Michael Barr says that because Fannie and Freddie are "owned by the taxpayers in the middle of the biggest housing crisis in 80 years," it would be unrealistic to expect the companies wouldn't be used to help stabilize the market. He says the administration's actions have been "prudent" and "consistent with taxpayer protection." The companies are political lightning rods. The government's decision to absorb unlimited losses followed the Treasury's approval of multimillion-dollar pay packages for senior executives at each company. Republican critics have blasted those decisions, demanding investigations and pay cuts.
Massachusetts Democratic Rep. Barney Frank, a longtime supporter of the companies, said last month that ultimately they should be abolished and replaced with an entirely new housing-finance system. Last Thursday, he said he would convene a hearing next month to review the future of housing finance and the federal government's role in it Some housing experts contend that prolonged government intervention will make it more difficult and costly to eventually wean the companies off government support. "The more aggressively we continue kicking the can down the road, the larger the losses become and the harder it becomes" to address the companies' future, says Joshua Rosner, managing director at investment-research firm Graham Fisher & Co.
Edward DeMarco, acting director of Fannie and Freddie's regulator, the FHFA, says efforts to modify loans and to stabilize the housing market ultimately will help the two companies' bottom lines. "The businesses are trying to mitigate the losses and remediate the problems that led to conservatorship in the first place," he says. As mortgage delinquencies rise, Fannie and Freddie are required to set aside more capital to cover anticipated losses. Each quarter, if their revenues are insufficient to meet those financial needs, the Treasury has to kick in more money. With delinquencies still rising, the outlook is grim. At Freddie, 3.87% of single-family mortgages were at least 90 days past due at the end of December, up from 1.72% a year earlier. Fannie is worse: 5.29% were 90 days past due in November, up from 2.13% a year earlier.
For decades, both Fannie and Freddie were highly profitable. The housing bust hit both hard, sharply reducing the values of the mortgages they guaranteed, along with their investment portfolios, which were stuffed with riskier loans. By September 2008, their capital reserves were so depleted that the government seized control of both companies, using a legal process known as conservatorship. In exchange for injecting money, the government has received preferred shares that pay a 10% dividend, along with warrants to purchase up to 79.9% of the common stock of each company.
The Obama administration had said it would weigh in on how to revamp the companies when it released its proposed budget earlier this month. Instead, the budget contained only a single line about the companies' future, promising to "monitor the situation" and to "provide updates…as appropriate." That stance reflects policy makers' uncertainty about how to proceed and a lack of urgency about resolving the problem. Lawrence Summers, the president's chief economic adviser, has said the companies shouldn't be run permanently by the U.S. or be allowed to "return to the failed model of the past, where Fannie and Freddie relied on an implicit government [debt] guarantee to borrow cheaply."
Some Republicans have said the government should play no role whatsoever in the companies in the future, meaning no implied debt guarantee and no government directives to support affordable housing. The other end of the spectrum would be to turn the companies into government agencies. Many housing-industry leaders believe the eventual plan will fall somewhere in between. Housing-policy experts assembled by the Center for American Progress, a think tank that has provided the White House input on past policy and personnel decisions, recently proposed that Fannie and Freddie be transformed into two or more companies whose profits would be capped like those of public utilities. There would be explicit federal guarantees on certain mortgage-backed securities. The new entities would be required to ensure that mortgages are available to low-income borrowers.
Others have proposed turning the companies into cooperatives owned by lenders, but subject to strict regulation. With the fate of the two companies now largely in the hands of the government, employees have shifted their attention to the administration's loan-modification effort, called Home Affordable Modification Program, or HAMP. It provides financial incentives for banks and other owners of mortgages to reduce monthly loan payments for at-risk borrowers. Fannie and Freddie's job is to oversee how loan servicers—the firms that collect monthly payments on mortgages—are working with homeowners on the front lines.
The program is off to a slow start. The administration said it would offer three million to four million borrowers the chance to modify loans. Through December, loan servicers have signed up 903,000 borrowers for trial modifications. Just 66,000 have received a permanent fix so far. Both Fannie and Freddie have struggled at times to adjust to the new marching orders. Fannie has warned in financial filings that the modification program had shifted "significant levels of internal resources and management attention" from other parts of the business, which could lead to a "material adverse effect" on the business.
At Freddie, David Moffett, the chief executive who took over when the federal government assumed control, left last March after only six months, partly because it became clear that regulators would be calling the shots. He says he and others warned administration officials that the loan-modification goals were unrealistic, that borrowers whose homes weren't worth what they owed were unlikely to take part, and that many participants would be likely to re-default within months. "They really didn't want our views," Mr. Moffett says.
Treasury's Mr. Barr says that isn't true. The Fannie and Freddie officials he worked with, he says, "were quite supportive of the program, of the structure and the basic design," and "were integral to the formulation." Since then, Freddie has taken some heat for problems with part of the loan-modification drive. In an October report, the government said Freddie failed in its job as the program's auditor. Its task is to make sure loan servicers deal correctly with applications from borrowers for payment relief. Freddie says it has reassigned the vice president responsible for the effort.
Freddie's current chief executive, Mr. Haldeman, 61 years old, says it was immediately "very clear" to him that the loan-modification program was a top priority of the Obama administration. But the program isn't his only headache. As foreclosures mount, Freddie finds itself with title to more and more homes. The company wants to price them to sell, but doesn't want to put downward pressure on overall housing prices. "Imagine having to keep the lawns mowed, the lights on, and the property secured for one house, let alone more than 40,000 homes all over the country," says Mr. Haldeman. "It's not an easy process."
John A. Koskinen, a turnaround specialist who became chairman of Freddie's board when the government stepped in, says that in all his years working for government agencies and troubled companies, "I've never been in one with as many challenges." Last spring and summer, as interim CEO, he had to recruit executives to fill the top three jobs. Filling those jobs has put the company on firmer ground, he says, and having a clear mission—even a government-mandated one—is helping morale. "At least the getting yelled at by your neighbor in the grocery store is behind us," he says. Loan standards today are tighter than they have been in decades. That means the default risk on loans guaranteed recently by Fannie and Freddie is much lower than it was a few years ago. But their mistakes during the housing boom are expected to continue burning holes in their balance sheets.
The Mortgage Bankers Association estimates that mortgage delinquencies won't peak any sooner than the middle of this year. At the current pace, around 6% of Fannie's loans and 4.9% of Freddie's are expected to go into default over the next 18 to 24 months, producing losses that would raise the price tag on Treasury's bailout to $175 billion, according to October estimates by investment bank Keefe, Bruyette & Woods Inc. The bank has since said that even that dire forecast is too optimistic. Former FHFA head James Lockhart, the companies' top regulator until last August, says the U.S. is unlikely to ever fully recoup its investment in the two companies.
Revised Baseline Scenario: February 9, 2010
by Peter Boone, Simon Johnson, and James Kwak
This material was the basis of testimony to the Senate Budget Committee today by Simon Johnson.
A. Main Points
1) In recent months, the US economy entered a recovery phase following the severe credit crisis-induced recession of 2008-09. While slower than it should have been based on previous experience, growth has surprised on the upside in the past quarter. This will boost headline year-on-year growth above the current consensus for 2010. We estimate the global economy will grow over 4 percent, as measured by the IMF’s year-on-year headline number (their latest published forecast is for 3.9 percent), with US growth in the 3-4 percent range – calculated on the same basis.
2) But thinking in terms of these headline numbers masks a much more worrying dynamic. A major sovereign debt crisis is gathering steam in Europe, focused for now on the weaker countries in the eurozone, but with the potential to spillover also to the United Kingdom. These further financial market disruptions will not only slow the European economies – we estimate growth in the euro area will fall to around 0.5 percent Q4 on Q4 (the IMF puts this at 1.1 percent, but the January World Economic Outlook update was prepared before the Greek crisis broke in earnest) – it will also cause the euro to weaken and lower growth around the world.
3) There are some European efforts underway to limit debt crisis to Greece and to prevent the further spread of damage. But these efforts are too little and too late. The IMF also cannot be expected to play any meaningful role in the near term. Portugal, Ireland, Italy, Greece, and Spain – a group known to the markets as PIIGS, will all come under severe pressure from speculative attacks on their credit. These attacks are motivated by fiscal weakness and made possible by the reluctance of relatively strong European countries to help out the PIIGS. (Section B below has more detail.)
4) Financial market participants buy and sell insurance for sovereign and bank debt through the credit default swap market. None of the opaqueness of the credit default swap market has been addressed since the crisis of September 2008, so it is hard to know what happens as governments further lose their credit worthiness. Generalized counter-party risk – the fear that an insurer will fail and thus bring down all connected banks – is again on the table, as it was after the collapse of Lehman.
5) Another Lehman/AIG-type situation lurks somewhere on the European continent, and again G7 (and G20) leaders are slow to see the risk. This time, given that they already used almost all their scope for fiscal stimulus, it will be considerably more difficult for governments to respond effectively if the crisis comes.
6) In such a situation, we should expect that investors scramble for the safest assets available – “cash”, which means short-term US government securities. It is not that the US has anything approaching a credible medium-term fiscal framework, but everyone else is in much worse shape.
7) Net exports have been a relative strength for the US economy over the past 12 months. This is unlikely to be the case during 2010.
8) In addition to this new round of global problems, the US consumer is beset by problems – including a debt overhang for lower income households, a soft housing market, and volatile asset prices. The savings rate is likely to fall from 2009 levels, but remain relatively high. Residential investment is hardly likely to recover in 2010 and business investment is too small to drive a recovery.
9) On a Q4-on-Q4 basis, the US will struggle to grow faster than 2 percent (the IMF forecast is for 2.6 percent). This within year pattern will likely involve a significant slowdown in the second half – although probably not an outright decline in output. The effects of fiscal stimulus will begin to wear off by the middle of the year and without a viable medium-term fiscal framework there is not much room for further stimulus – other than cosmetic “job creation” measures.
10) The Federal Reserve will start to wind down its extraordinary support programs for mortgage-backed securities, starting in the spring (although this may be delayed to some degree by international developments). The precise impact is hard to gauge, but this will not help prevent a slowdown in the second quarter.
11) On top of these issues, there is concern about the levels of capital in our banking system. The “too big to fail” banks are implicitly backed by the US government and for them the stress test of early 2009 played down the amount of capital they would need if the economy headed towards a “double-dip”-type of slowdown; the stress scenario used was far too benign. In addition, small and medium sized banks have a considerable exposure to commercial real estate, which continues to go bad.
12) Undercapitalized banks tend to be fearful and curtail lending to creditworthy potential borrowers. This may increasingly be the situation we face in 2010.
13) Emerging markets are also likely to slow in the second half of the year. Twice recently we have assessed whether these economies can “decouple” from the industrialized world (in early 2008 and at the end of 2008). In both cases, emerging markets – with their export orientation and, for some, dependence on commodity prices – were very much caught up in the dynamics of richer countries’ cycle.
14) The IMF projects global growth, 4th quarter-on-4th quarter within 2010 at 3.9 percent, i.e., the same as their year-on-year forecast. We expect it will be closer to 3 percent.
15) Over a longer time-horizon, we will probably experience a global economic boom, based on prospects in emerging markets. With our current global financial structure, this brings with it substantial systemic risks (see Section C below).
B. From Greece to the US: The Globalized Financial Transmission Mechanism
1) The problems now spreading from Greece to Spain, Portugal, Ireland and even Italy portend major trouble ahead for the US in the second half of this year – particularly because our banks remain in such weak shape.
2) Greece is a member of the eurozone, the elite club of European nations that share the euro and are supposed to maintain strong enough economic policies. Greece does not control its own currency – this is in the hands of the European Central Bank in Frankfurt. In good times, over the past decade, this helped keep Greek interest rates low and growth relatively strong.
3) But under the economic pressures of the past year, the Greek government budget has slipped into ever greater deficit and investors have increasingly become uncomfortable about the possibility of future default. This impending doom was postponed for a while by the ability of banks – mostly Greek – to use these bonds as collateral for loans from the European Central Bank (so-called “repos”).
4) But from the end of this year, the ECB will not accept bonds rated below A by major ratings agencies – and Greek government debt no longer falls into this category. If the ECB will not, indirectly, lend to the Greek government, then interest rates will go up in the future; in anticipation of this, interest rates should rise now.
5) This spells trouble enough for an economy like Greece – or any of the weaker eurozone countries. Paying higher interest rates on government debt also implies a worsening of the budget; these are exactly the sort of debt dynamics that used to get countries like Brazil into big trouble.
6) The right approach would be to promise credible budget tightening over 3-5 years and to obtain sufficient resources – from within the eurozone (the IMF is irrelevant in the case of such a currency union) – to tide the country over in the interim.
7) But the Germans have decided to play hardball with their weaker neighbors – partly because those countries have not lived up to previous commitments. The Germans strongly dislike bailouts – other than for their own banks and auto companies. And the Europeans policy elite loves rules; in this kind of situation, their political process will move at a relatively slow late 20th century pace.
8) In contrast, markets now move in a 21st century global network pace. We are moving towards is a full-scale speculative attack on sovereign credits in the eurozone. Brought on by weak fundamentals – worries about the budget deficit and whether government debt is on explosive path – such attacks take on a life of their own. We should remember – and prepare for – a spread of pressure between countries along the lines of the panic that moved from Thailand to Malaysia and Indonesia, and then then jumped to Korea all in the space of two months during 1997.
9) The equity prices of weaker European banks will come under pressured. Fears about their solvency may also be reflected in higher credit default swap spreads, i.e., a higher cost of insuring against their default.
10) US Treasury and the White House apparently take the view that they must stand aloof, waiting for the Europeans to get their act together. This is a mistake – the need for US leadership has never been greater, particularly as our banks are really not in good enough shape to withstand a major international adverse event (e.g., Greece defaults, Greece leaves the eurozone, Germany leaves the eurozone, etc).
11) We subjected our banks to a stress test in spring 2009 – but the stress scenario was mild and more appropriate as a baseline. Many of our banks – big, medium, and small – simply do not have enough capital to withstand further losses.
12) As the international situation deteriorates – or even if it remains at this level of volatility – undercapitalized banks will be reluctant to lend and credit conditions will tighten around the US.
13) If the European situation spins seriously out of control, as it may well do in coming weeks, the likelihood of a double-dip recession (or significant slowdown in the second half of 2010) increases dramatically.
C. Longer Run Baseline Scenario
1) In terms of thinking about the structure of the global economy there are three main lessons to be learned from the past eighteen months.
2) First, we have built a dangerous financial system in Europe and the U.S., and 2009 made it more dangerous.
- The fiscal impact of the financial crisis was to increase by around 30-40 percent points our federal government debt held by the private sector. The extent of our current contingent liability, arising from the failure to deal with “too big to fail” financial institutions, is of the same order of magnitude.
- Our financial leaders have learnt that they can bet the bank, and, when the gamble fails, they can keep their jobs and most of their wealth. Not only have the remaining major financial institutions asserted and proved that they are too big to fail, but they have also demonstrated that no one in the executive or legislative branches is currently willing to take on their economic and political power.
- The take-away for the survivors at big banks is clear: We do well in the upturn and even better after financial crises, so why fear a new cycle of excessive risk-taking?
3) Second, emerging markets were star performers during this crisis. Most global growth forecasts made at the end of 2008 exaggerated the slowdown in middle-income countries. To be sure, issues remain in places such as China, Brazil, India and Russia, but their economic policies and financial structures proved surprisingly resilient and their growth prospects now look good.
4) Third, the crisis has exposed serious cracks within the euro zone, but also between the euro zone and the U.K. on one side and Eastern Europe on the other. Core European nations will spend a good part of the next decade bailing out the troubled periphery to avoid a collapse. For many years this will press the European Central Bank to keep policies looser than the Germanic center would prefer.
5) Over the past 30 years, successive crises have become more dangerous and harder to sort out. This time not only did we need to bring the fed funds rate near to zero for “an extended period” but we also required a massive global fiscal expansion that has put many nations on debt paths that, unless rectified soon, will lead to their economic collapse.
6) For now, it looks like the course for 2010 is economic recovery and the beginning of a major finance-led boom, centered on the emerging world.
7) But this also implies great risks. The heart of the matter is, of course, the U.S. and European banking systems; they are central to the global economy. As emerging markets pick up speed, demand for investment goods and commodities increases –countries producing energy, raw materials, all kinds of industrial inputs, machinery, equipment, and some basic consumer goods will do well.
8) On the plus side, there will be investment opportunities in those same emerging markets, be it commodities in Africa, infrastructure in India, or domestic champions in China.
9) The Chinese exchange rate will remain undervalued. Our reliance on Chinese purchases of US government and agency debt puts us at a significant strategic disadvantage and makes it hard for the administration to push for revaluation. The existing multilateral mechanisms for addressing this issue – through the IMF – are dysfunctional and will not help. There is a growing consensus to move exchange issues within the remit of the World Trade Organization but, without US leadership, this will take many years to come to fruition.
10) Good times will bring surplus savings in many emerging markets. But rather than intermediating their own savings internally through fragmented financial systems, we’ll see a large flow of capital out of those countries, as the state entities and private entrepreneurs making money choose to hold their funds somewhere safe – that is, in major international banks that are implicitly backed by U.S. and European taxpayers.
11) These banks will in turn facilitate the flow of capital back into emerging markets –because they have the best perceived investment opportunities – as some combination of loans, private equity, financing provided to multinational firms expanding into these markets, and many other portfolio inflows. Citigroup, for example, is already emphasizing its growth strategy for India and China.
12) We saw something similar, although on a smaller scale, in the 1970s with the so-called recycling of petrodollars. In that case, it was current-account surpluses from oil exporters that were parked in U.S. and European banks and then lent to Latin America and some East European countries with current account deficits.
13) That ended badly, mostly because incautious lending practices and – its usual counterpart – excessive exuberance among borrowers created vulnerability to macroeconomic shocks.
14) This time around, the flows will be less through current- account global imbalances, partly because few emerging markets want to run deficits. But large current-account imbalances aren’t required to generate huge capital flows around the world.
15) This is the scenario that we are now facing. For example, savers in Brazil and Russia will deposit funds in American and European banks, and these will then be lent to borrowers around the world (including in Brazil and Russia).
16) Of course, if this capital flow is well-managed, learning from the lessons of the past 30 years, we have little to fear. But a soft landing seems unlikely because the underlying incentives, for both lenders and borrowers, are structurally flawed.
17) The big banks will initially be careful – although Citigroup is already bragging about the additional risks it is taking on in India and China. But as the boom progresses, the competition between the megabanks will push toward more risk-taking. Part of the reason for this is that their compensation systems remain inherently pro-cyclical and as times get better, they will load up on risk.
18) The leading borrowers in emerging markets will be quasi-sovereigns, either with government ownership or a close crony relationship to the state. When times are good, investors are happy to believe that these borrowers are effectively backed by a deep-pocketed sovereign, even if the formal connection is pretty loose. Then there are the bad times – remember Dubai World at the end of 2009 or the Suharto family businesses in 1997-98.
19) The boom will be pleasant while it lasts. It might go on for a number of years, in much the same way many people enjoyed the 1920s. But we have failed to heed the warnings made plain by the successive crises of the past 30 years and this failure was made clear during 2008-09.
20) The most worrisome part is that we are nearing the end of our fiscal and monetary ability to bail out the system. In 2008-09 we were lucky that major countries had the fiscal space available to engage in stimulus and that monetary policy could use quantitative easing effectively. In the future, there are no guarantees that the size of the available policy response will match the magnitude of the shock to the credit system.
21) Much discussion of the Great Depression focuses on the fact that the policy response was not sufficiently expansionary. This is true, but even if governments had wanted to do more, it is far from clear that they had the tools at their disposal – in particular, the size of government relative to GDP is limited, while the scale of financial sector disruption can become much larger.
22) We are steadily becoming more vulnerable to economic disaster on an epic scale.
In Brooklyn, Mortgage Crisis Eats Away Wealth of Several Generations of Hispanics
by Eva Sanchis
Ramona Ortiz, 46, looks inside a big black bag of accumulated invoices for an explanation as to why she and her family are about to lose the home that has been theirs since 1972. “Honestly, I didn’t check the papers properly, and who knows what is in there,” she admits, suspiciously looking at the pile of documents produced by the mortgages the family acquired in the last few years. That black bag hides a bitter reality: In 1998, Ramona’s father, José Dolores Ortiz, had paid in full the $21,750 cost of the three-story house on 931 Bushwick Avenue. Today he owes nearly $330,000 for the same house. During the last eleven months, José, a 78-year-old Puerto Rican retired worker of a watch trading company, who receives a $950 pension, has been unable to make the monthly $1,684 mortgage payments. Now he could lose the house where he lived with his wife until she passed away and where his four grandchildren were born, two of whom still live with him.
“My father worked all his life, even after retiring,” says Ramona Ortiz, who grew up in that house. “My parents always paid their bills on time; they paid their mortgage three or four months ahead… This is something new,” she regrets. “I didn’t know what a mortgage was until we started with this”. Ortiz claims that everything began when her father decided to get a new mortgage on the house in 2001, to help her pay a credit card debt. According to public records, he later refinanced his mortgage five times between 2003 and 2007, which increased the debt from some $29,000 in 2001 to nearly $330,000. During the years prior to the recent real estate collapse, in the predominantly Hispanic neighborhood of Bushwick, populated by nearly 130,000 people, high-cost or subprime loans and costly refinancing proliferated, encouraged by brokers and mortgage companies, many of which were based in faraway states.
“There was the start of a phenomenon at one point where brokers would go back to the homeowner every year and get them to refinance,” says Sara Manaugh, an attorney who represents low-income homeowners facing foreclosure at South Brooklyn Legal Services. “People were encouraged to treat their homes as piggy banks, taking the cash out from their refinancing. They were told that their property would continue to appreciate, but they got another bad end of that deal.” Closing costs should be around 4% to 6% of a new loan, but with unscrupulous brokers many people ended up paying 8% or 10% of that loan amount to their brokers, according to city housing counselors.
These practices prompted an epidemic of foreclosures in other areas of the country. In New York City, the crisis is concentrated in certain black and Hispanic neighborhoods, like southeastern Queens and central Brooklyn. In 2006, black owners in the city received five times more high-cost loans (which entail a higher risk) than whites, while Hispanics received three and half times more, according to a study by the Furman Center at New York University. In 2007, the Bushwick Community District had tripled the average number of high-cost loans in the city. Between 2006 and the end of 2009, there were 1,598 mortgage defaults in Bushwick, the majority concentrated in the southeastern area of the neighborhood, where the Ortiz family lives.
Abandoned homes are a common sight around the Ortiz home, with boarded-up windows and doors, and mail and trash piling up. Some homes have been occupied by the homeless or even by the former owners themselves. “Many of the squatters used to live in the buildings themselves and they come back because they don’t have anywhere to go,” says Sergio Negrón, who lives next to an empty building on Harman Street that was reoccupied during several months by several Hispanic families. The neighbors would rather not discuss the problem, says Ramona Ortiz. “I know that something is going on because people I have known for a long time here, they don’t live there any more. The houses are empty,” she says. “We got this house on the corner with some people, all of a sudden they disappear and someone else is living there. There is a couple of houses around the corner, same thing,” she adds.
Of her several refinancing mortgages, Ortiz remembers the last one clearly, from February 2007: Ortiz called for information regarding a broker who had left business cards in the neighborhood. Representatives from the broker made an appointment with her elderly father, without her knowledge, and made him sign the contract when he was alone at home with an underage granddaughter, Ortiz says. Ramona’s father, José Dolores Ortiz, doesn’t remember today much about that afternoon, he only knows that he depends on his daughter to take care of all the paperwork related with the house. “She is the one who takes care of the paperwork, she is the one who does everything, I ask her everything and do everything that she says,” says José Ortiz, who seems to have trouble hearing and understanding this reporter’s questions.
The family paid more than $17,000 in closing costs, including nearly $14,000 in broker fees. They also received about $20,000 in cash, $15,000 of which was to pay for home repairs made by a contractor linked to the broker, says Ortiz. “Everything was very fast. They called and made an appointment, and next thing I know is that there are people on the roof, people in the windows making repairs,” recalls Ortiz, who later discovered that the $1,684 monthly payments that they thought would cover 30 years would be increased to more than $2,400 over 10 years. For a while her father had a tenant and could pay the mortgage, but when her father fell sick and the tenant left in 2008, he was unable to make the mortgage payments, says Ortiz. “It was either the bills, eating or the mortgage,” Ortiz says.
Peter Digi, an employee with Lexington Capital Corporation, the broker based in Queens hired by the Ortiz family, disputes the family account. He insists everything was legal and no one was misrepresented. “To close a mortgage is not a one-day thing that no one could have known about,” says Digi. “We do thousands of loans a month, they supplied us with documents, they signed disclosures, they went to a closing and signed the closing papers in front of attorneys and notaries.” Digi adds that the mortgage was a good one for the Ortiz family, because they received about $32,000 in cash and paid off a $16,000 credit card debt. “I wish the customer luck and all, but it’s nothing that we can do or did wrong here,” says Digi. “People fall behind and they look for people to blame to get out of their problems. It’s unfortunate, but this is the world we live in.”
Mike Mastman, a foreclosure prevention counselor from Grow Brooklyn, a Bushwick-based non profit, who is counseling the Ortiz family free of charge, says that many homeowners were pressured by brokers into refinances and mortgages that they could not afford. “Brokers work on commission but do not work for the company that actually holds the loan,” says Mastman. “Some unscrupulous brokers seemed to believe it would never come back to them if they signed people up for mortgages they could not afford.” These abusive practices in Bushwick stem from the ostracizing treatment that its residents endured and have been subjected to for years by the banks, experts say.
The Ortiz family’s neighborhood only has two bank branches and a credit cooperative. However, there are thirteen check cashing locations and five pawnshops, according to data compiled in 2009 by NEDAP, a New York organization that fights against discriminatory financial practices. “The problem has existed for many years because either large banks like Chase or Citibank were not in the community or if they were they didn’t grant loans to residents,” says Herman de Jesús, senior program associate at NEDAP. “But it worsened when mortgage companies realized that the banks were not lending and said: we are going to offer you loans, but we are going to charge you double or triple,” he adds.
Many Hispanic homeowners like the Ortiz, who contributed to Bushwick’s rebirth from poverty and crime following the 1977 blackout, when entire blocks were burnt and vandalized, now face the loss of the only wealth accumulated during a lifetime. “We have lost at least a generation of wealth and that’s the tragedy of this,” says Vicki Been, director of the Furman Center. “You got families who struggled so hard to get that piece of the American dream, to get home ownership, and now they have lost everything and that will have ripple effects for generations, because wealth people build up on their homes is often used to send the next generation to college or start a small business.” Ortiz says that she and her daughters are struggling to help with the payments and keep the house at least while her father is alive: “If I lose the house while he is still alive, that would kill him, because here is where he wants to live until the end.”