"Launch of fire boat James Battle, Wyandotte, Michigan"
Ilargi: There's undoubtedly a lot of theater sense down here (after all, we're watching a two-bit play), but not as much as there is confusion. Which is perfectly understandable, and swings both or even all ways. Everyone’s eager to figure out the plot.
A "real upward swing based on compelling observations", as a comment on this site phrased it, would seem to need to ignore the headlines I started off with last time:
- "US bank lending falls at the fastest rate in history"
- "Lending to British businesses falls at record pace"
- "UK mortgage lending falls to 10-year low
- "Shock as British deficit equals that of Greece" and
- "Britain posts first deficit for January since records began".
- "Lending to British businesses falls at record pace"
But people are sufficiently addicted to upswings to see much of anything as compelling. It's like Leonard Cohen said: "Why don't you join the Rosicrucians, they will give you back your hope".
If in February 2010, after trillions have been spend and lost with much more on the same way (re: Fannie and Freddie), the reality is that lending in the private sector drops by and to record levels, while borrowing by the public sector reaches record highs, the conclusion seems obvious and truly compelling. But it's nothing to do with an upward swing, and it doesn't evoke a mental high.
Our "leaders" have done the only thing they can think of, being the one-dimensional one trick ponies they are: throw trillions of dollars against the wall and hope some of it sticks.
Well, as longtime predicted here, nothing does, and that's what those headlines say!
And yes, there are still those who point to the last bits of goo that haven't quite fallen to the floor yet (look, we created a job!), but we should all know by now that the entire idea has turned out to be a giant failure, as I've always said it must be; simply, for stimulus to work, you need more than free money to throw around, no matter what Krugman says, or Bernanke, or Obama. You don’t need a theory, you need a plan and you need guts. Still, all we get are theories. Throw more against that wall.
There's no way I can be too far off when I say that in the US alone, the stimulus over the past year and change has cost the American people about a trillion dollars a month, which whey will never see again. Now we're running out of money to lose, the Fed tightens, and it's getting to be time to turn around and see if your loved ones are where you are in a position to best take care of them.
The suggestion that in the situation we soon will live in money is the only thing that counts in that endeavor strikes me as particularly blinded. It may be true that today, 10 cents can buy you a tomato, but what happens if one tomato buys you a hundred dollars? It doesn't seem to be the height of smart to presume that money will rule the world the same it's done in the society whose last days we witness. If money rules, more money rules more, but that ends when there's so much money turned into debt it loses its capacity to rule, simply because you can't still eat the stuff.
I can't make people see what they don't want to, but I think it's a grave mistake not to see what those headlines say. And "a real upward swing" misses the point by a trillion miles. We’re swinging alright, but we're doing it the Wile. E. way.
There've been lots of -greatly overdone- reports about how hard it will be for Germany and Holland to sell a bail-out of Greece to their people. Well, the Frankfurter Allgemeine newspaper has another one for you: let’s see how Americans react when they find out it's the US that bails out Greece because a failure to do so would trigger massive CDS obligations for AIG, now a de facto US government operation. That could be the mother of all tea parties. Record numbers of unemployed at home, and Washington bails out Greece. Cue Tina Fey, center stage left.
Meanwhile, it’s highly entertaining to see the usual cabal of experts and analysts (try the ones Bloomberg incessantly quotes, mice and monkeys have far better success rates) scream that the Euro is getting hammered, and the US stands out as some kind of great economics beacon, which they claim to prove by pointing at the "rising" dollar. Have all these geniuses bet on the wrong horse? Come to think of it, how could they not?
One more time for the guys in the velvet seats: Germany is driving down the Euro, and it's using Greece to do it. For perspective: Until a few months ago, Germany, a country of just 80 million souls, was the world’s largest exporter. The economic crisis, therefore, has obviously been doubly triply hard on the country. And then on top of that the Euro gained some 20% in a year versus the US dollar. That one-two left hook and uppercut might have killed off a lesser party. But under these circumstances, Germany's GDP growth in Q4 2009 came in at 0%. Not minus 20%, as might have been expected. The German economy was hit twice, and it has hardly even budged. But that 0% growth number of course was presented by the experts panel as a sign of weakness. It's the exact opposite.
When I look at the US, I think it would be a very good thing if Washington included all its liabilities in future budgets, up to and including Fannie Mae, Freddie Mac, Ginnie Mae, FHLB and FHA, since that would provide a much clearer (dare I say honest?) picture of where the country stands. It would also be murder on the dollar. Curiously (for many), the US is not the only party that wants the trillions in mortgage losses off the American books. Germany wants the exact same thing, something all these experts seem to be completely oblivious to.
We have entered the beggar-thy-neighbor phase of the downfall, the race to the bottom is on for currencies. Obama's ludicrous call to double US exports in 5 years fits that same idea. The one viable way left to soften the fall is to entice other countries to buy your products, because that's the only money you don't have to borrow. But you can't achieve that goal with a strong currency. China knows that all too well and keeps the renminbi pegged to the USD. Everything they own is denominated in dollars anyway. But if Germany gets its way, the Chinese currency will rise with the dollar, until the latter is on par with the Euro (it’s €1 to $1.36 today). Once that is done, Germany hopes to once again be the world's largest exporter.
But do note that these sorts of policies don’t come from a position of strength, for none of the parties involved, including China, and any and all talk of recovery is ridiculous while they are ongoing.
This is not a fight for a meal of kings, this is a down and dirty scramble about the scraps off the table.
'Buy farmland and gold,' advises Dr Doom
The world’s most powerful investors have been advised to buy farmland, stock up on gold and prepare for a "dirty war" by Marc Faber, the notoriously bearish market pundit, who predicted the 1987 stock market crash. The bleak warning of social and financial meltdown, delivered today in Tokyo at a gathering of 700 pension and sovereign wealth fund managers. Dr Faber, who advised his audience to pull out of American stocks one week before the 1987 crash and was among a handful who predicted the more recent financial crisis, vies with the Nouriel Roubini, the economist, as a rival claimant for the nickname Dr Doom.
Speaking today, Dr Faber said that investors, who control billions of dollars of assets, should start considering the effects of more disruptive events than mere market volatility. "The next war will be a dirty war," he told fund managers: "What are you going to do when your mobile phone gets shut down or the internet stops working or the city water supplies get poisoned?" His investment advice, which was the first keynote speech of CLSA’s annual investment forum in Tokyo, included a suggestion that fund managers buy houses in the countryside because it was more likely that violence, biological attack and other acts of a "dirty war" would happen in cities. He also said that they should consider holding part of their wealth in the form of precious metals "because they can be carried".
One London-based hedge fund manager described Mr Faber’s address as "excellent, chilling stuff: good at putting you off lunch, but not something I can tell clients asking me about quarterly returns at the end of March". Dr Faber did offer a few more traditional investment tips, although their theme fitted his general mode of pessimism. In Asia, particularly, he said, stock pickers should play on future food and water shortages by buying into companies with exposure to agriculture and water treatment technologies.
One of Dr Faber’s darker scenarios involves growing military tension between China and the United States over access to limited oil resources. Today the US has a considerable advantage over China because it has free access to oceans on both coasts, and has potential energy suppliers to the north and south in Canada and Mexico. It also commands an 11-strong fleet of aircraft carriers that could, if necessary, secure supply routes in a conflict situation. China and emerging Asia, meanwhile, face the uncertainty of supplies that must travel from the Middle East through winding sea lanes and the Malacca bottleneck.
American military presence in Central Asia, Dr Faber said, may add to the level of concern in Beijing. "When I tell people to prepare themselves for a dirty war, they ask me: "America against whom?" I tell them that for sure they will find someone." At the heart of Dr Faber’s argument is a fundamentally gloomy view on the US economy and its capacity to service a growing mountain of debt. His belief, fund managers were told, is that the US is going to go bankrupt.
Under President Obama, he said, the country’s annual fiscal deficit will not drop below $1 trillion and could rise beyond that figure. Arch bears have predicted that US debt repayments could hit 35 per cent of tax revenues within ten years. Dr Faber believes that the ratio could easily hit 50 per cent in the same time frame.
The New Poor: Millions of Unemployed Face Years Without Jobs
Even as the American economy shows tentative signs of a rebound, the human toll of the recession continues to mount, with millions of Americans remaining out of work, out of savings and nearing the end of their unemployment benefits. Economists fear that the nascent recovery will leave more people behind than in past recessions, failing to create jobs in sufficient numbers to absorb the record-setting ranks of the long-term unemployed.
Call them the new poor: people long accustomed to the comforts of middle-class life who are now relying on public assistance for the first time in their lives — potentially for years to come. Yet the social safety net is already showing severe strains. Roughly 2.7 million jobless people will lose their unemployment check before the end of April unless Congress approves the Obama administration’s proposal to extend the payments, according to the Labor Department.
Here in Southern California, Jean Eisen has been without work since she lost her job selling beauty salon equipment more than two years ago. In the several months she has endured with neither a paycheck nor an unemployment check, she has relied on local food banks for her groceries. She has learned to live without the prescription medications she is supposed to take for high blood pressure and cholesterol. She has become effusively religious — an unexpected turn for this onetime standup comic with X-rated material — finding in Christianity her only form of health insurance. "I pray for healing," says Ms. Eisen, 57. "When you’ve got nothing, you’ve got to go with what you know."
Warm, outgoing and prone to the positive, Ms. Eisen has worked much of her life. Now, she is one of 6.3 million Americans who have been unemployed for six months or longer, the largest number since the government began keeping track in 1948. That is more than double the toll in the next-worst period, in the early 1980s. Men have suffered the largest numbers of job losses in this recession. But Ms. Eisen has the unfortunate distinction of being among a group — women from 45 to 64 years of age — whose long-term unemployment rate has grown rapidly.
In 1983, after a deep recession, women in that range made up only 7 percent of those who had been out of work for six months or longer, according to the Labor Department. Last year, they made up 14 percent. Twice, Ms. Eisen exhausted her unemployment benefits before her check was restored by a federal extension. Last week, her check ran out again. She and her husband now settle their bills with only his $1,595 monthly disability check. The rent on their apartment is $1,380. "We’re looking at the very real possibility of being homeless," she said.
Every downturn pushes some people out of the middle class before the economy resumes expanding. Most recover. Many prosper. But some economists worry that this time could be different. An unusual constellation of forces — some embedded in the modern-day economy, others unique to this wrenching recession — might make it especially difficult for those out of work to find their way back to their middle-class lives. Labor experts say the economy needs 100,000 new jobs a month just to absorb entrants to the labor force. With more than 15 million people officially jobless, even a vigorous recovery is likely to leave an enormous number out of work for years.
Some labor experts note that severe economic downturns are generally followed by powerful expansions, suggesting that aggressive hiring will soon resume. But doubts remain about whether such hiring can last long enough to absorb anywhere close to the millions of unemployed.
A New Scarcity of Jobs
Some labor experts say the basic functioning of the American economy has changed in ways that make jobs scarce — particularly for older, less-educated people like Ms. Eisen, who has only a high school diploma. Large companies are increasingly owned by institutional investors who crave swift profits, a feat often achieved by cutting payroll. The declining influence of unions has made it easier for employers to shift work to part-time and temporary employees. Factory work and even white-collar jobs have moved in recent years to low-cost countries in Asia and Latin America. Automation has helped manufacturing cut 5.6 million jobs since 2000 — the sort of jobs that once provided lower-skilled workers with middle-class paychecks.
"American business is about maximizing shareholder value," said Allen Sinai, chief global economist at the research firm Decision Economics. "You basically don’t want workers. You hire less, and you try to find capital equipment to replace them." During periods of American economic expansion in the 1950s, ’60s and ’70s, the number of private-sector jobs increased about 3.5 percent a year, according to an analysis of Labor Department data by Lakshman Achuthan, managing director of the Economic Cycle Research Institute, a research firm. During expansions in the 1980s and ’90s, jobs grew just 2.4 percent annually. And during the last decade, job growth fell to 0.9 percent annually. "The pace of job growth has been getting weaker in each expansion," Mr. Achuthan said. "There is no indication that this pattern is about to change."
Before 1990, it took an average of 21 months for the economy to regain the jobs shed during a recession, according to an analysis of Labor Department data by the National Employment Law Project and the Economic Policy Institute, a labor-oriented research group in Washington. After the recessions in 1990 and in 2001, 31 and 46 months passed before employment returned to its previous peaks. The economy was growing, but companies remained conservative in their hiring. Some 34 million people were hired into new and existing private-sector jobs in 2000, at the tail end of an expansion, according to Labor Department data. A year later, in the midst of recession, hiring had fallen off to 31.6 million. And as late as 2003, with the economy again growing, hiring in the private sector continued to slip, to 29.8 million.
It was a jobless recovery: Business was picking up, but it simply did not translate into more work. This time, hiring may be especially subdued, labor economists say. Traditionally, three sectors have led the way out of recession: automobiles, home building and banking. But auto companies have been shrinking because strapped households have less buying power. Home building is limited by fears about a glut of foreclosed properties. Banking is expanding, but this seems largely a function of government support that is being withdrawn. At the same time, the continued bite of the financial crisis has crimped the flow of money to small businesses and new ventures, which tend to be major sources of new jobs.
All of which helps explain why Ms. Eisen — who has never before struggled to find work — feels a familiar pain each time she scans job listings on her computer: There are positions in health care, most requiring experience she lacks. Office jobs demand familiarity with software she has never used. Jobs at fast food restaurants are mostly secured by young people and immigrants. If, as Mr. Sinai expects, the economy again expands without adding many jobs, millions of people like Ms. Eisen will be dependent on an unemployment insurance already being severely tested. "The system was ill prepared for the reality of long-term unemployment," said Maurice Emsellem, a policy director for the National Employment Law Project. "Now, you add a severe recession, and you have created a crisis of historic proportions."
Some poverty experts say the broader social safety net is not up to cushioning the impact of the worst downturn since the Great Depression. Social services are less extensive than during the last period of double-digit unemployment, in the early 1980s. On average, only two-thirds of unemployed people received state-provided unemployment checks last year, according to the Labor Department. The rest either exhausted their benefits, fell short of requirements or did not apply. "You have very large sets of people who have no social protections," said Randy Albelda, an economist at the University of Massachusetts in Boston. "They are landing in this netherworld."
When Ms. Eisen and her husband, Jeff, applied for food stamps, they were turned away for having too much monthly income. The cutoff was $1,570 a month — $25 less than her husband’s disability check. Reforms in the mid-1990s imposed time limits on cash assistance for poor single mothers, a change predicated on the assumption that women would trade welfare checks for paychecks. Yet as jobs have become harder to get, so has welfare: as of 2006, 44 states cut off anyone with a household income totaling 75 percent of the poverty level — then limited to $1,383 a month for a family of three — according to an analysis by Ms. Albelda. "We have a work-based safety net without any work," said Timothy M. Smeeding, director of the Institute for Research on Poverty at the University of Wisconsin, Madison. "People with more education and skills will probably figure something out once the economy picks up. It’s the ones with less education and skills: that’s the new poor."
Here in Orange County, the expanse of suburbia stretching south from Los Angeles, long-term unemployment reaches even those who once had six-figure salaries. A center of the national mortgage industry, the area prospered in the real estate boom and suffered with the bust. Until she was laid off two years ago, Janine Booth, 41, brought home roughly $10,000 a month in commissions from her job selling electronics to retailers. A single mother of three, she has been living lately on $2,000 a month in child support and about $450 a week in unemployment insurance — a stream of checks that ran out last week.
For Ms. Booth, work has been a constant since her teenage years, when she cleaned houses under pressure from her mother to earn pocket money. Today, Ms. Booth pays her $1,500 monthly mortgage with help from her mother, who is herself living off savings after being laid off. "I don’t want to take money from her," Ms. Booth said. "I just want to find a job." Ms. Booth, with a résumé full of well-paid sales jobs, seems the sort of person who would have little difficulty getting work. Yet two years of looking have yielded little but anxiety. She sends out dozens of résumés a week and rarely hears back. She responds to online ads, only to learn they are seeking operators for telephone sex lines or people willing to send mysterious packages from their homes.
She spends weekdays in a classroom in Anaheim, in a state-financed training program that is supposed to land her a job in medical administration. Even if she does find a job, she will be lucky if it pays $15 an hour. "What is going to happen?" she asked plaintively. "I worry about my kids. I just don’t want them to think I’m a failure." On a recent weekend, she was running errands with her 18-year-old son when they stopped at an A.T.M. and he saw her checking account balance: $50. "He says, ‘Is that all you have?’ " she recalled. " ‘Are we going to be O.K.?’ " Yes, she replied — and not only for his benefit. "I have to keep telling myself it’s going to be O.K.," she said. "Otherwise, I’d go into a deep depression."
Last week, she made up fliers advertising her eagerness to clean houses — the same activity that provided her with spending money in high school, and now the only way she sees fit to provide for her kids. She plans to place the fliers on porches in some other neighborhood. "I don’t want to clean my neighbors’ houses," she said. "I know I’m going to come out of this. There’s no way I’m going to be homeless and poverty-stricken. But I am scared. I have a lot of sleepless nights." For the Eisens, poverty is already here. In the two years Ms. Eisen has been without work, they have exhausted their savings of about $24,000. Their credit card balances have grown to $15,000. "I don’t know how we’re still indoors," she said.
Her 1994 Dodge Caravan broke down in January, leaving her to ask for rides to an employment center. She does not have the money to move to a cheaper apartment. "You have to have money for first and last month’s rent, and to open utility accounts," she said. What she has is personality and presence — two traits that used to seem enough. She narrates her life in a stream of self-deprecating wisecracks, her punch lines tinged with desperation. "See that," she said, spotting a man dressed as the Statue of Liberty. Standing on a sidewalk, he waved at passing cars with a sign advertising a tax preparation business. "That will be me next week. Do you think this guy ever thought he’d be doing this?"
And yet, she would gladly do this. She would do nearly anything. "There are no bad jobs now," she says. "Any job is a good job." She has applied everywhere she can think of — at offices, at gas stations. Nothing. "I’m being seen as a person who is no longer viable," she said. "I’m chalking it up to my age and my weight. Blame it on your most prominent insecurity."
Two Incomes, Then None
Ms. Eisen grew up poor, in Flatbush in Brooklyn. Her father was in maintenance. Her mother worked part time at a company that made window blinds. She married Jeff when she was 19, and they soon moved to California, where he had grown up. He worked in sales for a chemical company. They rented an apartment in Buena Park, a growing spread of houses filling out former orange groves. She stayed home and took care of their daughter. "I never asked him how much he earned," Ms. Eisen said. "I was of the mentality that the husband took care of everything. But we never wanted." By the early 1980s, gas and rent strained their finances. So she took a job as a quality assurance clerk at a factory that made aircraft parts. It paid $13.50 an hour and had health insurance.
When the company moved to Mexico in the early 1990s, Ms. Eisen quickly found a job at a travel agency. When online booking killed that business, she got the job at the beauty salon equipment company. It paid $13.25 an hour, with an annual bonus — enough for presents under the Christmas tree. But six years ago, her husband took a fall at work and then succumbed to various ailments — diabetes, liver disease, high blood pressure — leaving him confined to the couch. Not until 2008 did he secure his disability check. And now they find themselves in this desert of joblessness, her paycheck replaced by a $702 unemployment check every other week. She received 14 weeks of benefits after she lost her job, and then a seven-week extension.
For most of October through December 2008, she received nothing, as she waited for another extension. The checks came again, then ran out in September 2009. They were restored by an extension right before Christmas. Their daughter has back problems and is living on disability checks, making the church their ultimate safety net. "I never thought I’d be in the position where I had to go to a food bank," Ms. Eisen said. But there she is, standing in the parking lot of the Calvary Chapel church, chatting with a half-dozen women, all waiting to enter the Bread of Life Food Pantry. When her name is called, she steps into a windowless alcove, where a smiling woman hands her three bags of groceries: carrots, potatoes, bread, cheese and a hunk of frozen meat.
"Haven’t we got a lot to be thankful for?" Ms. Eisen asks. For one thing, no pinto beans. "I’ve got 10 bags of pinto beans," she says. "And I have no clue how to cook a pinto bean." Local job listings are just as mysterious. On a bulletin board at the county-financed ProPath Business and Career Services Center, many are written in jargon hinting of accounting or computers. "Nothing I’m qualified for," Ms. Eisen says. "When you can’t define what it is, that’s a pretty good indication." Her counselor has a couple of possibilities — a cashier at a supermarket and a night desk job at a motel. "I’ll e-mail them," Ms. Eisen promises. "I’ll tell them what a shining example of humanity I am."
80% Of Today's Delinquent Homeowners Will Lose Their Houses
Irvine-based John Burns Real Estate Consulting Inc. made national news this past week with a study showing that a new wave of foreclosures will hit the U.S. housing market in the next few years.
According to the Wall Street Journal, Burns Consulting’s study forecast that despite loan modification efforts, the nation has a “shadow inventory” of 5 million units that will be added to the housing market as their delinquent owners lose their homes. This shadow inventory is equal to about 10 months supply of homes.
Wayne Yamano, Burns Consulting vice president, co-wrote the study. We asked him to explain their findings.
Us: What did your study into shadow inventory entail and what were your key findings? How did you define "shadow inventory" for the purposes of this study?
Wayne: In our study, we set out to figure how large the shadow inventory problem is nationally, and to quantify shadow inventory MSA by MSA. We define shadow inventory as the supply of homes that will be lost by currently delinquent homeowners and is not yet available for sale.
Us: Your study says that five million of the 7.7 million delinquent homes will go through foreclosure or a "foreclosure-related procedure." How is this likely to occur?
Wayne: Most shadow inventory will get out onto the market as an REO or short sale. In any event, it results in the homeowner losing their home, and that home being added to the supply of homes available for sale.
Us: Do the remaining 2.7 million borrowers get their loan payments caught up?
Wayne: Of the 7.7 million delinquent homeowners, we actually think that only about 1.6 million will be able avoid losing their homes, and that the remaining 6.1 million will lose their homes. We say that there is 5 million units of shadow inventory because we estimate that about 1.1 million delinquent homeowners already have their homes listed for sale, and we would not classify those homes as "shadow."
Us: When will this wave of foreclosures hit, and how will this shadow inventory affect home prices?
Wayne: We don’t believe that the shadow inventory will be dumped onto the market all at once. Although we don’t believe modification efforts will truly save a lot of homeowners from losing their homes, we do believe that these programs are effective in delaying foreclosures and pushing out the additional supply to later years.
In terms of pricing, as long as the economic recovery continues and mortgage rates remain low, we do NOT expect another leg down in pricing, despite the looming shadow inventory problem. However, if the economy takes another dip and mortgage rates spike, we’re certain to see another decline in prices.
Us: Any indication how bad the problem is in Orange County?
Wayne: Orange County has about 13 months of shadow inventory, which is above the national average, but lower than other Southern California metros.
Us: What are the key implications of your findings?
Wayne: Our main conclusion is that prices are likely to keep steady, despite the massive shadow inventory, because the tremendous affordability we have today will create a floor for pricing. However, if the economic recovery stalls or mortgage rates spike, we’re going to see prices tumble again.
The fever-curve of the Greek debt crisis: Will the US bail out Greece?
by Markus Frühauf
Trade in the risk of Greek insolvency in the past five months has enabled fantastic earnings. That is made clear by the price-development for credit-default insurance on that financially-weak Euroland. On 16 October 2009 a Credit Default Swap (CDS), which investors use to insure themselves against insolvency from Athens, still cost 123 basis points (1.23 percentage points). This meant a yearly premium of 12,300 euros in order to insure a claim on 1 million euros. On 4 February the insured had to pay 42,820 euros for that, a fee three times as high. Greece’s risk-premium – in market jargon the CDS spread – is the fever-curve of the debt crisis.
For the growth in the expense of the insurance against non-payment reflects the reduced creditworthiness of the country. Speculation in the CDS market began after 4 October 2009, as the Greek Socialists celebrated their election victory. Two weeks later the newly-elected government informed its Euro-partners that the deficit for 2009 was going to lie at 12.7 percent of economic performance (GDP).
Timidly, but steadily
That was a shock, since the previous conservative government had prognosticated precisely half of that. The new estimate for the budget deficit called onto the stage the first hedge funds, reports a London CDS-dealer working for a large American bank. In view of Greece’s previous history of cheating its way into the monetary union with false budget statistics, at that point a wager on Greece having payment problems was promising. This bet in the meantime has become obvious.
The rise of the Greek risk-premium at first still continued timidly, but steadily. It could be that that hedge funds had been the first to recognize Athens’ exhausted budget situation but had bet in the CDS market on a fall in the value of Greek debt with little commitment of capital. But the new Greek government’s commitment to transparency unleashed this speculation. The further rises in the CDS spread were accompanied by fundamental factors as well. On 8 December 2009 the Fitch rating agency downgraded Greece’s credit-rating from "A-" to "BBB+". The Euroland found itself in the same category as Estonia or South Africa in its credit-worthiness. One week later Standard & Poor’s followed. Here, too, the Greeks flew out of the "A-" class denoting particularly good solvency. In this period the CDS price exceeded the mark of 200 basis-points for the first time. With these rating-downgrades the fear of a possible Greek insolvency grew by leaps and bounds on the financial markets and among Europartner countries.
Unusually high interest-coupon
A first high-point was reached when the Greek finance minister issued a new five-year loan at the end of January. The offer of 8 billion euros encountered a demand among investors three times as great. This was a calming signal only at first glance. For Greece had to fit out the loan with an unusually high interest-coupon of 6.1 percent. With this the country was playing with a risk-premium in a league with Vietnam. This fed doubt on the debt market as to whether Greece under these conditions could sustain its debt-service over the long-run – in the first instance when in April and May 20 billion euros will have to be refinanced.
Besides all that, this led to a technical effect. The old loans already on the market still bore a lower interest-coupon. They were issued back when the credit-rating for Greece still lay in the "A-" range. Some investors were forced to shift into the new debt instruments with the higher interest. In the wave of selling the yield on ten-year Greek debt increased to over 7 percent. Whoever in October had bet on Greece having payment difficulties was now rewarded: the CDS spread now clearly lay over 400 basis-points. The initial investment had more than tripled when the payment-protection was sold on.
The CDS market is influenced by the same factors as the debt market. This was evident from the falling-back of the CDS premium when signs of financial support for Athens from Europartner countries multiplied. But the problem with the CDS is that this market is much more opaque. These contracts are handled over-the-counter among banks, thus in an unregulated environment. You can also speculate much more favorably aided by credit-default derivatives than on the loan market, for there is a significantly lesser commitment of capital required.
In any case, the CDS-wager has gone up because more and more true-believers in the Greek State have come to feel the need to insure their holdings. This rapidly-rising demand for insurance has been set off by the escalation of the debt crisis. But it is past Greek governments that have to answer in the first place for the exhausted budget situation. The higher demand for insolvency protection that has driven up the CDS price follows from the evidently poorer estimation of Greek credit-worthiness.
Greek banks as insurers
On the other hand, whoever expected Greece’s rescue by Europartner countries would have had to position himself on the CDS market as an insurer, that is, as a seller of payment protection. The take in premiums from insurance protection sold provides increased revenue. But it’s on the seller-side that the weak points of the CDS market become evident. It’s still unclear who has sold insurance protection for Greece. In one study analysts from the major French bank BNP Paribas referred to market-rumors that Greek banks had insured a large sum by CDS. If this is correct, then the payment protection they have provided is worth nothing. Greek banks hold State debt of over 40 billion euros. This corresponds roughly to the entire amount of equity in the Greek credit market. A bankruptcy of the State would lead to a collapse of the banking system.
London investment bankers name AIG as a further CDS-seller. That company had to be nationalized during the financial crisis due to its having written insolvency insurance on American mortgages. This debt-load would have led to the collapse of the world’s biggest insurer. Prior to the financial crisis AIG is said to have widely held State credit-risk. If yet-larger insurance positions on Greece exist, then the American government would have a strong interest in preventing that country’s insolvency.
Even if these are mere rumors about the Greek banks and AIG, this example makes clear the weakness of CDS markets. This protection is sold by banks or insurers who themselves have access only to limited capital resources. They have as a rule clearly lesser credit-worthiness than the states for which they are selling insolvency protection. Insurance by CDS could turn out to be just a bubble.
Eurozone lines up $34 billion Greek aid
A Greek bailout package worth up to €25 billion (£22 billion, $34 billion) is being put together by eurozone finance ministers, according to German reports. The financial assistance would include loans and guarantees, with the burden being spread between members of the European single currency. It is understood that Germany would put up €4 billion to €5 billion. The plan emerged as Greece prepares to launch a multibillion-euro bond in a move that will test its credibility in the financial markets. It also comes amid concerns over the UK’s fiscal position, which continues to hit the value of the pound. Sterling lost almost 2% against the dollar and 1% against the euro last week.
However, Britain may have limped out of recession slightly faster than previously thought. Revised figures due this week from the Office for National Statistics are expected to show the economy grew by 0.2% in the last three months of 2009. The initial estimate of fourth-quarter GDP suggested growth of just 0.1%. The improved performance is likely to be a result of stronger than anticipated industrial production and a marginal upward revision in service sector output. Figures last week showed the sharpest drop in high street spending for 18 months. Poor weather was blamed for a 1.8% reduction in sales between December and January.
Three-way poker in Greek debt crisis
The man at the center of Greece's debt crisis is surviving on 4-5 hours sleep a night and could not get to his office last week because it was blockaded by striking employees. "We know we don't have a blank check," Finance Minister George Papaconstantinou told Reuters in an interview at a temporary refuge in a tax and customs administration building. "We have public support as long as people feel everyone is bearing the burden equally."
Papaconstantinou is trying to make the most of a weak hand in a three-way poker game involving Greece, its European Union partners and the financial markets. Greece needs to borrow or refinance 53 billion euros ($71.52 billion) this year, including 20 billion in April and May. "We want to be able to borrow on the same terms as other countries in the euro zone," Prime Minister George Papandreou told a conference in London last Friday. But investors anxious at the risk that Athens may be overwhelmed by its debts, projected to hit 120 percent of gross domestic product this year, are charging a steep premium to buy Greek bonds rather than benchmark German bunds.
The government needs to slash a huge budget deficit fast to assuage angry European partners and restore credibility in the bond markets, without squeezing voters so hard that it triggers a social revolt in a famously rebellious country. Papaconstantinou is looking for clearer EU support to help escape a vicious circle of rising borrowing costs, harsher austerity measures, prolonged recession and diminished revenue. Having owned up to a massive under reporting of its deficit and promised swift corrective action, Greece's negotiating leverage with its EU partners is mostly negative. It can dramatize the risks for the entire euro zone if its debt woes get worse, it can point to the danger of social unrest if the EU forces too harsh austerity on Greeks, and it can threaten to go to the International Monetary Fund. The government is doing a little of each while stressing its utter determination to meet steep deficit reduction targets.
"The real threat, which they may eventually have to use, is not default, or leaving the euro zone, but going to the IMF," said Loukas Tsoukalis, a former top policy adviser to European Commission President Jose Manuel Barroso. "That would look serious for the euro zone because we share a common currency. After all, Colorado doesn't go to the IMF," said Tsoukalis, president of Athens' Eliamep policy think-tank. Euro zone heavyweights France and Germany have insisted that the Greek problem should be handled within the European family. After EU leaders declared their support on February 11 for Athens' deficit-cutting program and vowed coordinated action, if needed, to safeguard stability in the euro zone, markets were looking for a clear signal of how Europe would help Greece.
It didn't come. Debt spreads, which fell on expectations of an EU rescue package, have crept up again as markets see the public backlash in Germany and question Berlin's willingness to make any financial commitment to Greece. These doubts come just as Athens is hoping to go back to the market with its next 10-year bond issue. After talks with EU colleagues last week, Papaconstantinou said in the interview: "We need to give the assurance to markets that we are actually working toward a potential instrument of "xyz" type, so that we'll never have to use it." He did not rule out seeking IMF assistance but he said there were no negotiations with the global lender now.
Seen from Brussels and Berlin, it is too early to ease pressure on Athens by spreading out a European safety net that would be deeply unpopular with German, Dutch and Finnish voters. EU ministers reckon Greece should take more drastic steps quickly to cut its public wage bill, raise value added tax and further increase fuel tax to achieve a promised deficit reduction this year of 4 percent of GDP. The government is waiting until after a one-day general strike by the two main trade unions this week against its public sector wage freeze, tax hikes and welfare cuts before deciding on any further measures. Papaconstantinou hopes that by April, Greece will have impressed markets with the initial execution of its fiscal adjustment, won further approval from Brussels and secured a clearer EU guarantee to back its borrowing. "My only choice is to accelerate what we are doing here, be as public about it as we can, grit our teeth until things quieten down and pay the higher cost," the minister said.
Europe's monetary union has become an instrument of deflation torture
by Ambrose Evans-Pritchard
If the purpose of the euro was to bind Europe's tribes together and serve as catalyst for political union, EU elites must have been chastened by the outpouring of anti-German feeling in the Greek parliament last week. The Left called for war damages for Axis occupation and accused German banks of playing a "wretched game of profiteering at the expense of the Greek people". Mainstream New Democracy was no nicer. "How does Germany have the cheek to attack us over our finances when it has still not paid compensation for Greece's war victims? There are still Greeks weeping for lost brothers," said ex-minister Margaritis Tzimas.
This is deeply hurtful to Germany, a vibrant democracy that has played its difficult part in Europe for 60 years with dignity. No country could have done more to overcome its demons. It has paid the EU bill, and paid again, rarely grumbling. Yet a decade of monetary union has created such a wide and self-perpetuating gap between North and South that everything in EU affairs is poisoned. German-Greek relations are the worst in my lifetime. Nobel economist Paul Krugman said there is no point blaming any one country for this "Euromess". "Europe's policy elite bears the responsibility," he said. "It pushed hard for the single currency, brushing off warnings that exactly this sort of thing might happen, although even eurosceptics never imagined it would be this bad." Actually, we did, Professor. Thanks anyway.
EMU is slowly suffocating boom-bust states trapped in debt deflation, acting in the same perverse and destructive fashion as the Gold Standard in the 1930s. Gold rules were simple: surplus states loosened, deficit states tightened. This preserved equilibrium. World War One shattered the system. The US was not ready to take the guiding role from Britain. The dollar was undervalued in the 1920s. America ran vast surpluses, like China today. So did France, which re-pegged too low. Both drained the world's bullion. Yet neither loosened: the Fed because Chicago liquidationists ran amok; the Banque de France because its post-War brush with hyperinflation was still fresh.
Adjustment fell entirely on deficit states such as Britain. They had to tighten into the downturn, feeding debt deflation. Global demand imploded on itself until the entire system collapsed. In the end, the US and France were victims of their obduracy, but that was not clear in 1930, or 1931, except to Keynes. This is the story of Euroland. The North is in surplus, the South in deficit. Germany's current account surplus was 6.4pc of GDP in 2008, Holland's 7.5pc. Club Med deficits topped 14pc for Greece, and 10pc for Iberia. The gap has narrowed since but remains structural.
This is an intra-EMU version of China's surplus with the West. But at least China is doing something about it with a fiscal blitz and 30pc growth in the money supply. Germany has banned budget deficits, implying a fiscal squeeze next year. IG Metall has agreed to a pay freeze, undercutting Spanish and Italian unions yet again. How can Club Med close a 30pc gap in unit labour costs against deflating Germany? Brussels is enforcing an EU-version of Pierre Laval's deflation decrees in 1935, the policy that tipped France's Third Republic over the edge. It has ordered Greece to cut the deficit by 10pc of GDP in three years or face the whip under Article 126.9. Spain must squeeze 8pc. France next?
The European Central Bank is letting deflation run its course. Business credit is falling at a 2.3pc rate, while M3 money continues to contract. Frankfurt says demand for loans has slackened, so this does not matter. We will find out. German growth fell to zero in the fourth quarter as state stimulus faded. Italy turned negative again. Spain never left recession. This recovery has `L-shaped' all over it. Dr Krugman said EMU had lured Spain into a debt bubble and left the country exposed to an "asymmetric shock" with no defence. "If Spain had had its own currency, that currency might have appreciated during the real estate boom, then depreciated when the boom was over. Since it didn't and doesn't, however, Spain now seems doomed to suffer years of grinding deflation and high unemployment." He wants higher inflation to rescue eurozone deflators from their trap. So does the IMF, implicitly. But who in Europe will or can take that decision?
Albert Edwards from Société Générale said governments should use their powers over the exchange rate under Article 219 to force a change in policy. "The politicians should take matters into their own hands and instruct the ECB to drive the euro lower," he said. That can happen only once France thinks the dangers of Laval policies outweigh the dangers of defying Bundesbank orthodoxy. Until then EMU will be an instrument of slow deflation torture.
Forget Europe And China, All Eyes Are Turning To Crumbling Treasuries
Every day it seems the US markets get knocked around due to some events happening overseas. China and Europe have been trading places as the tail wagging our dog, though last week was mercifully light on China news due to the New Year.
And seeing as they've just finished a round of delivering fresh economic news and a rate hike, we might expect things to be somewhat quiet out of Beijing in the near-term. The situation in Europe remains anyone's guess. So now the focus turns back to America, and our own unique set of issues.
Two big themes both relating to interest rates will dominate the discussion. First there's Bernanke's fiddling with the uber-short end of the curve (so short, even, it doesn't actually show up). And then there's the fresh focus on long-term yields.
That's where the battle is going to take place.
Treasury bears have been out in force for awhile, but they smell blood right now, in part helped by some recent very-weak bond auctions.
So there you go. The below chart from Waverly Advisors, which we've run before, is a nice quick way of visualizing the changing curve year over year.
Wall Street's Gravy Train Is About To Hit A Brick Wall
The major banks are loving the uber-steep yield curve that allows them to borrow money on the cheap, and then lend it back to the government at a fat yield. Well, that's just about over. Bernanke has signalled the beginning of the rate-hike cycle (driving up the cost of short-term borrowing) and as this historical chart of the 2year-10-year yield spread (via Waverly Advisors) indicates, the curve just can't get any steeper. In fact if history is any guide, it's about to collapse big time.
The One Chart That Scares Richard Russell
Nothing would derail the Fed’s great reflation/recovery experiment like higher interest rates. Several notable investors including David Einhorn and Julian Robertson, have expressed their concerns over the potential for higher interest rates. The great Richard Russell of the Dow Theory Letters has long feared a spike in interest rates. In a recent note he explained that the end of quantitative easing has bond investors worried over the future of interest rates. Russell believes higher rates are the next big move in the bond market:"Older subscribers may remember that I said that the Fed could continue its "quantitative easing" (printing money) until the bond market says it can’t. Below is a daily chart of the 30-year Treasury bond. The bond market doesn’t like what it sees. I view the pattern on this chart as a huge, down-slanting head-and-shoulder top with the bond sitting right on support. The bond appears weak, and if support is violated, interest rates will be heading higher. And that’s the last thing the Fed wants at this time."
Citi Warns of Withdrawal Gate
Seen on a recent Citibank statement: "Effective April 1, 2010, we reserve the right to require (7) days advance notice before permitting a withdrawal from all checking accounts. While we do not currently exercise this right and have not exercised it in the past, we are required by law to notify you of this change."
Whoa. Is this an April Fool's joke? A contingency plan to defend against the idea of what "would happen if thousands of [bank] customers pledge to withdraw their money from the bank on a certain day, unless the bonuses are capped?" A strategem cooked up by Citi's new shareholders from the hedge fund industry, an industry in which such withdrawal gates are common? An idea backed by Citi's big shareholder, Uncle Sam, or one of its regulators, Sheila Bair?
I called Citi about it and they said the warning applies only to customers in Texas and that the notification had been mistakenly included on statements nationwide. Whatever the explanation, it doesn't exactly inspire confidence in Citi. I've got nothing against Citi as a general matter -- I have friends who work there, and know some account holders who are generally satisfied customers. But it's hard to believe a bank would be sending out a notice like that on its statements.
Update: Citibank has now released the following statement by way of explanation: "When Citibank moved to unlimited FDIC coverage in 2009, we had to reclassify many checking accounts to allow for immediate withdrawals in order to ensure all customers qualified for the additional coverage. When we moved back to standard FDIC coverage with most major banks in 2010, Citibank decided to reclassify those accounts back to make them eligible again for promotional incentives. To do so, Federal Reserve Reg D requires these accounts, called NOW accounts, to reserve the right to require a 7-day notice of withdrawal. We recently communicated this technical requirement to our customers. However, we have never exercised this right and have no plans to do so in the future."
Credit-Card Fees: the New Traps
New Law Allows Some Aggressive Lender Tactics to Continue
A new federal credit-card law that takes effect Monday could erase billions of dollars a year in fees and interest charges paid by consumers. But card issuers are already deploying new tactics that could prove costly for even the most cautious cardholder. The law made some important changes. Card companies must now tell customers how long it would take to pay off the balance if they only make the minimum monthly payment. Customers can only exceed their credit limit if they agree ahead of time to pay a penalty fee. And unless a cardholder misses payments for more than 60 days, interest-rate increases will affect only new purchases, not existing balances.
Banning these and other profitable tactics is expected to cost the card industry at least $12 billion a year in lost revenue, according to law firm Morrison & Foerster. This has sent the industry scrambling to find new sources of revenue. So get ready for higher annual fees, higher balance-transfer charges, and growing charges for overseas transactions. "There are countless fees that can be introduced and rates can go through the roof," says Curtis Arnold, founder of U.S. Citizens for Fair Credit Card Terms Inc., a consumer-advocacy group. Consider the new offer from Citigroup Inc. The bank will give cardholders a credit of 10% on their total interest charge if they pay on time. That sounds enticing, except that if you don't pay on time, your interest rate is 29%.
The new regulations, dubbed the Credit Card Accountability Responsibility and Disclosure Act of 2009, couldn't come at a worse time for banks, which have been trying to rebuild balance sheets hit hard by the collapse of the housing bubble and the recession. Now, their credit-card operations are getting pounded by a downturn in spending and sharply higher defaults as unemployed Americans and other cash-strapped customers stop paying their debts. Last year, Bank of America Corp. and J.P. Morgan Chase & Co. suffered combined net losses of $7.8 billion in their credit-card operations, and this year will bring more red ink unless there is a miracle rebound.
The banks could be hurt further as consumers try to clean up their finances, especially high-cost credit card debt. The average American was running a credit-card balance of just over $5,400 at the end of 2009, down about $200 from five years ago, according to TransUnion, a Chicago-based firm that tracks credit data. In such an environment, consumers may push back against new card fees or jump to a rival issuer determined to compete by keeping fees low or nonexistent.
All this represents a huge change from three years ago when banks were tripping over themselves to issue credit cards to just about anybody, and consumers were on a spending spree. Banks have pruned many of their more profligate cardholders, and are using higher transaction fees to raise more money from cardholders who pay their bills each month rather than run up huge balances. The biggest new tactic may be one of the oldest: raising rates. As long as credit-card companies inform you ahead of time and don't make any sudden rate changes, they are mostly free under the law to charge whatever they want. They can raise the rate on new purchases made as long as they provide 45 days notice that they are doing so.
U.S. banks on average increased the interest rate on their credit cards by about two percentage points between December 2008 and July 2009, according to Pew Charitable Trusts, a nonprofit group. Some consumers say that their accounts have been hit with sudden interest-rate increases even if they haven't been late on a payment. Bank of America says it hasn't raised interest on credit-card accounts since the law was passed last spring, except in the case where a cardholder has repeatedly paid late. In a statement, Citigroup said: "We understand that customers don't like price increases, especially in difficult economic times. However, these actions are necessary given the doubling of credit card losses across the industry from customers not paying back their loans and regulatory changes that eliminate re-pricing for that risk."
Card companies also plan to collect more interest by switching customers to variable-rate cards from fixed-rate cards. Variable rates, which are linked to an index like the prime rate, are low now. But they give the companies more flexibility to collect a higher rate in the future as long as they alert customers to the terms now. Many card companies have already sent out notices that change the terms of the card contract to a higher or variable rate. Cardholders should expect to see more fees for extra services, such as requesting a year-end itemization of all your purchases, paper statements or getting extended warranties on purchases. "You're going to see a lot more tricks in terms of fees," said Robert Manning, author of "Credit Card Nation" and founder of the Responsible Debt Relief Institute.
Banks already are reaping more fees on overseas transactions. Not only are they raising foreign-exchange transaction fees—the cost customers pay for purchases made in foreign currencies—but they are expanding the definition of what qualifies as a foreign transaction. In the past, people who made online purchases from foreign merchants, or who traveled to a country where the purchases are often in U.S. dollars such as the Bahamas, were generally immune from paying such fees. But Citi and Bank of America recently imposed their 3% foreign-transaction fees on all foreign transactions—even if that purchase is charged in U.S. dollars. Discover Financial Services also began charging a new 2% for foreign purchases last year.
American Express Co., which is known for its lucrative rewards programs, recently added new fees to its co-branded Hilton Hotels, Starwood Hotels and Delta Air Lines cards. Cardholders who pay late will lose their rewards points. They can reinstate them to their accounts if they pay a $29 fee. An American Express spokeswoman said the fees are consistent with policies on its other cards and is aimed at encouraging cardholders to pay their bills on time. For new customers, the days of 0% teaser rates and no-annual-fee boasts are dwindling. After cutting back substantially on mail offers, card companies are once again trying to woo new cardholders. But this time around, the avalanche of pitches are for cards that have annual fees or balance-transfer fees as high as 5% of the balance.
Avoiding such fees is sure to get trickier. Only about 20% of U.S. credit cards currently have an annual fee, according to industry statistics. But that number will likely rise because most direct-mail card offers are for premium cards loaded with reward programs—but also fees. Plain-vanilla cards that don't have any annual fees (or rewards programs) represented just 11% of mail offers in the fourth quarter, according to Mintel Comperemedia, which tracks credit-card mail offers. J.P. Morgan's Chase card unit and American Express are among those that have recently introduced new cards with annual fees. Consumers can fight back against some of the industry's tactics. You only need one or two credit cards that are widely accepted. So it can make sense consolidating debt on the card that has the lowest interest rate, assuming it makes sense after taking into account the balance-transfer fee.
True, shedding cards can hurt your credit score. But John Ulzheimer of Credit.com has a rule of thumb to preserve it while closing accounts: If you are able to keep your overall "credit utilization" on your cards—the amount of credit used as a percentage of your overall available credit—below 10% then closing accounts to avoid paying extra fees could make sense, he said. So use the card or lose it because there may be a price to pay for inactivity. Fifth Third Bancorp is charging customers $19 if they don't use their credit card in a year.
And there are ways to avoid annual fees. Citigroup is alerting some customers that it is assessing a $60 annual fee on their cards. The cure for that is simple. If you spend $2,400 on the card in a 12-month period, the bank will refund the fee. Bob Depweg, who owns a security-consulting firm in the Los Angeles area, intends to keep playing hardball in order to what he wants out of his credit-card companies. Since the law was passed by Congress, he says he has successfully convinced American Express to drop its annual fee on his card by threatening to take his business elsewhere. And when Citi raised the interest rate on his wife's credit card to 29.9% from 14%, he closed the account.
Regulations going into effect later this year will place even more constraints on credit-card companies. Starting Aug. 20, card companies will be required to review a customer's interest rate every six months. Consumers will have the right to tell a credit-card company that they don't accept a change of terms in their card agreement. The company will then be required to close the account and allow the customer to pay off the balance under the old terms. Consumers who carry a balance may want to steer clear of retail cards, which woo customers with discounts. The money you save in the beginning could be eclipsed by the higher rates these cards typically charge as you pay off the balance.
Credit unions often offer lower rates than large banks, although some of their rewards programs are less generous than those of big banks. There are more than 8,000 credit unions in the U.S., and they tend to have pretty expansive definitions of who can join. The criterion for joining some credit unions is as simple as your Zip Code. Navy Federal, the nation's largest retail credit union, offers rates as low as 7.9% on a basic platinum Visa card for three million members of the Army, Navy, Air Force, and Marine Corps and their families. That compares with an interest rate as low as 11.99% on a Citibank Platinum Select MasterCard, touted as one of the cheapest rates around by Lowcards.com, a card-comparison Web site. The average rate at the end of last year was roughly 14%, according to the Federal Reserve.
Besides rates, reward programs are one of the other big considerations in choosing the right card. Cash-back cards are likely to offer the best deals in the new regulatory environment since banks have been making their own reward programs less rewarding. They are shortening the expiration periods, raising redemption fees or implementing earnings caps on rewards. Although issuers have also been trimming cash-back rates in general—the standard rate today is 1% compared with 3% to 5% a few years ago—consumers can still earn higher rates by shopping in certain categories, such as gas or groceries. "For the average person, if you're going to do a loyalty rewards program, simple is best," said Mr. Manning of the Responsible Debt Relief Institute. "Take the cash back."
Elizabeth Warren: It's Bank Lobbyists vs. American Families In Fight For Financial Reform
Elizabeth Warren appeared on "Real Time With Bill Maher" Friday evening to discuss financial reform. Warren, the chair of the Congressional Oversight Panel for TARP, explained that banks and their lobbyists are hammering Congress and fighting against the interests of American families by blocking financial reform. The problems are obvious and the solutions are too, but for some reason, we can't seem to get the two together, Warren said. She admitted that during her first appearance on Maher's show six months ago, she believed that the country was on "the brink" of financial reform. Maher promptly asked her what she smoked before that show.
Eliot Spitzer: Reform Doesn't Come From Bipartisanship
Former New York Governor Eliot Spitzer, MSNBC Washington Correspondent Norah O'Donnell, and "Family Guy" creator Seth MacFarlane appeared on "Real Time With Bill Maher" Friday. The panel weighed in on everything from Obama's failure to communicate to financial reform, waterboarding, and Sarah Palin's son who has Down Syndrome. Spitzer had tough words for Barack Obama on and his constant search for bipartisanship. "Fundamental reform doesn't come from bipartisanship. And it seems to me bipartisanship has become appeasement. Barack Obama won an election based on a set of principles. Fight for them."
McFarlane agreed with Spitzer's remark about bipartisanship and advised Obama to be more like Bush. MacFarlane also answered Maher's questions about the controversy surrounding a recent "Family Guy" episode in which a character with Down Syndrome mocked Sarah Palin. On Obama's anti-terror efforts, O'Donnell pointed out that the Obama administration has continued and arguably intensified many of Bush's policies and yet Republicans have parodied the Obama White House as a "miranda-reading, soft on terror, professor-like administration."
U.S. Bank Failures in 2010 Rise to 20
Regulators shuttered four banks Friday, from Florida to California, as local banks continue to buckle across the country. Twenty banks have toppled so far in 2010 and 185 have failed since January 2008, with regulators expecting to close dozens more by the end of this year. The Federal Deposit Insurance Corp. estimated the four failures Friday cost its deposit insurance fund more than $1 billion. The largest bank to fail Friday was the 10-branch La Jolla Bank in California. Its $3.6 billion of assets made it the biggest bank to fail in 2010. The FDIC sold all of La Jolla's deposits and virtually all of its assets to OneWest FSB, a thrift created last year after investors bought up pieces of the failed IndyMac Bank. The FDIC and OneWest agreed to share future losses on $3.3 billion of the La Jolla Bank's deposits.
La Jolla Bank had a large concentration in residential real-estate loans, according to FDIC data. More than 11% of its loans were in default at the end of September. In Illinois, regulators closed the four-branch George Washington Savings Bank in Orland Park. The FDIC sold all of the failed bank's $397 million in deposits and virtually all of its $412.8 million in assets to FirstMerit Bank in Ohio. The FDIC and FirstMerit agreed to share future losses on most of those assets if they fall in value over time.
George Washington Savings Bank was founded in 1889. More than 21% of its loans were in default at the end of September, according to FDIC data. Twenty-three Illinois banks have failed since early 2009. State regulators also closed Marco Community Bank, the only federally insured bank headquartered on Florida's Marco Island. The FDIC sold the failed bank's $117.1 million of deposits to Mutual of Omaha Bank in Nebraska. Mutual of Omaha also bought almost all of Marco Community Bank's $119.3 million in assets, and the FDIC agreed to share future losses on those assets if they fell in value. Marco Community Bank had very low capital levels and had a high exposure to real-estate loans.
In Texas, federal regulators shut down La Coste National Bank, and the FDIC sold its $49.3 million in deposits to Community National Bank in Hondo, Texas. Community National Bank also agreed to buy virtually all of La Coste National Bank's $53.9 million in assets. The Texas bank had just one branch.
US State Governors Brace For More Economic Turmoil: 'Worst Probably Is Yet To Come'
On the recession's front lines, governors are struggling to chart the road ahead for states staggered by unrelenting joblessness and cut-to-the-bone budgets even as Washington reports signs of economic growth. "The worst probably is yet to come," warned Gov. Jim Douglas, R-Vt., chairman of the National Governors Association, at the group's meeting Saturday. He called the situation "fairly poor" in most states, adding that it "doesn't look too good." Such uncertainty weighed heavily over the governors' weekend meeting even though health care – and how states can address skyrocketing costs – was the intended focus. That's recognized as one of the biggest issues affecting states' long-term solvency.
As the meeting opened, first lady Michelle Obama sought governors' help in her campaign to tackle childhood obesity, though she acknowledged, "I know that many of you are stretched thinner than ever in these times and don't actually have money to spare." It's true. States face budget holes totaling $134 billion over the next three years, according to the governors, who explained that tax collections keep declining as Medicaid costs soar. High unemployment persists. States cut 18,000 jobs in January alone and more job losses are anticipated. Because states are required to balance their budgets, shortfalls will be made up by raising taxes or fees or cutting services. Neither is easy in an election year where 37 states are poised to vote for new chief executives.
While the national economy has grown in recent months, the situation is deteriorating in the states. People are feeling the fallout daily, from fewer services to higher fees. It's a trend consistent with other recessions; states usually experience their worst budget years in the two years after a recession ends. "A year ago we were facing an economic abyss. The president pulled us back from the brink. But we have more to do," said Delaware Gov. Jack Markell, the head of the Democratic Governors Association.
There seemed to be unanimous agreement that job creation was the key to recovery in states. "Our folks want to get back to work," said Gov. Chris Christie, R-N.J. Added Gov. Martin O'Malley, D-Md.: "It's the only way that we're going to get out of this recession." Nationwide, governors are drawing up plans to boost jobs and address the financial crisis that has led to repeated budget cuts and raids on rainy day funds. States have put a big dent in the $135 billion in federal stimulus money they got last year to soften the blow. Governors are hoping for an infusion of cash, perhaps $25 billion, in the latest jobs measure that Congress is debating. The national unemployment rate fell to 9.7 percent in January, but 17 states entered 2010 with double-digit joblessness.
"We need the administration and the Congress, members of both parties, to work to make sure a robust jobs bill is passed as quickly as possible so we can start seeing the benefits," Ohio Gov. Ted Strickland said. He joined fellow Democrats at a news conference to call for an extension of soon-expiring unemployment benefits and more access to working capital. The governors were holding sessions on the economy, energy, health care and education with Cabinet officials during the three-day gathering. Those issues, along with the jobs measure, are certain topics of discussion when governors head to the White House on Monday for a meeting with President Barack Obama. Democrats and Republicans alike said they hoped to press for more relief for states.
In the coming year, state tax collections are projected to continue to be far lower than expected because real estate values are plunging, people are losing their jobs and consumers are curtailing spending. Demand for services such as Medicaid, food stamps and unemployment benefits is all but certain to keep rising. People fretting about disappearing jobs and drying up unemployment benefits will feel the effects of whatever governors decide to do. Tough budget times typically translate into new tolls on roads, more prisoners released early to save money, the end of some state welfare programs and steeper tuition at public colleges. Republican and Democratic governors alike risk the ire of voters angry over high unemployment and sour on incumbents of any political stripe largely because of the poor economic conditions.
Among the most vulnerable Democrats seeking re-election are Strickland and Chet Culver of Iowa. Some of the Republicans in the same boat include Jan Brewer in Arizona and Jim Gibbons in Nevada. The economy also is certain to put the party in power's hold on governors mansions in doubt in a slew of other states, including Republican-held California and Florida, and Democratic-held Michigan and New York. "The governors who raise taxes will be hurt worse than the governors who have cut spending," predicted Mississippi Gov. Haley Barbour, chairman of the Republican Governors Association. He said people tend to give leaders credit who make tough choices to tighten their own belts in times of crisis.
Greece Hires Former Goldman Banker as Debt Chief
Greece replaced its debt management chief with a former Goldman Sachs Group Inc. investment banker, as declines in the country’s bonds roil European markets. Petros Christodoulou took over from Spyros Papanicolaou as head of the Athens-based Public Debt Management Agency, the Finance Ministry said yesterday in an e-mail. Christodoulou held positions in global markets at Credit Suisse Group AG, Goldman Sachs and JPMorgan Chase & Co. before joining National Bank of Greece in 1998, according to a company filing.
"The incoming guy is walking into a tough mandate," said Charles Diebel, senior interest-rate strategist at Nomura International Plc in London. "Such is the sentiment towards Greece at the moment, a new broom could be a positive." Greek bonds have slumped in the past two months, driving yields to the highest in 10 years, on concern the government will struggle to narrow a budget deficit that is more than four times the European Union limit. Prime Minister George Papandreou’s government needs to sell 53 billion euros ($72 billion) of debt this year, the equivalent of 20 percent of gross domestic product.
Christodoulou said in a telephone interview from Athens today that his appointment took effect immediately. He has yet to meet with his new colleagues and it’s "too early" to make any comment on debt strategy, he said. Papanicolaou said on Feb. 2 that Greece would sell 10-year bonds at the end of February or early March to prepare for about 20 billion euros of redemptions in April and May.
Christodoulou led the derivatives desk, then short-term interest-rate trading and emerging markets at JPMorgan as a managing director, the National Bank of Greece filing showed.
Goldman Sachs managed $15 billion of bond sales for Greece after arranging a currency swap that allowed the government to hide the extent of its deficit. No mention was made of the swap in documents for the securities in at least six of the 10 sales the bank arranged for Greece since the transaction, according to a review of the prospectuses by Bloomberg. The New York-based firm helped Greece raise $1 billion of off-balance-sheet funding in 2002 through the swap, which EU regulators said they knew nothing about until recently.
The Greek government is under pressure to show that it can reduce a budget deficit that was the equivalent to 12.7 percent of gross domestic product last year after the EU this week stopped short of offering financial support. The EU’s ceiling is 3 percent. The yield on Greek two-year notes has remained above 5 percent, the highest in the euro region, since Jan. 20, even after officials this week said they backed Greece’s plan to reduce the deficit. The premium investors demand to hold the notes instead of benchmark German securities fell 11 basis points today to 449. That spread reached 563 basis points on Feb. 8, the most since the Mediterranean nation joined the euro. It averaged 37 basis points in the past decade.
Greek bonds rose today, driving the yield on two-year government note 11 basis points lower to 5.53 percent as of 5:52 p.m. in London. The 10-year bond yield dropped 8 basis points to 6.45 percent.
Papanicolaou, a former central bank official, was appointed general director of the debt office by the previous New Democracy government in January 2005. His predecessor, Christopher Sardelis, had held the role since 1999, when the organization was created. "I’m not stepping down," Papanicolaou said in a telephone inter view yesterday.
"It’s normal" that a new government changes staff, he said. "It’s a long tradition. Whether it’s good or not, that’s another story." Christodoulou is a member of the Foundation for Economic and Industrial Research, the filing said. He holds a Bachelor of Science from the Athens School of Commerce and Economics and a Master of Business Administration in International Financial Markets from Columbia University. "It’s a very challenging job," Papanicolaou said. "We are going through a very difficult period."
Volcker Discusses The Housing Market, GSEs, Raising The Retirement Age and The Volcker Rule
Not too surprisingly, now that the old man is loose, he just refuses to keep his mouth shut about the true state of the economy. Also, unlike his interview with Maria Bartiromo, this time he doesn't just walk off the set. Some of the soundbites: "The mortgage market in the US is in trouble. It's totally dependent, heavily dependent on the government participation. It shouldn't be that way. That's going to have to be reconstructed." Another modest proposal from the former Fed chairman - raising the retirement age: "Social Security program should raise the retirement age by maybe a year or so." On the greatest blunder in the U.S. housing market: "Fannie Mae and Freddie Mac were not a good idea in the first place. This hybrid public/private thing sooner or later was going to get you in trouble and it sure got us in trouble big time! So I hope we don't go back to that model." And, lastly, on the most relevant issue at hand - the Volcker rule and defining commercial bank activities:"The criteria in my mind is, are you meeting a customer demand or are you trading in your own interest? Or are you responding to your customer's demand to sell or buy? I think that definition is clear and can be defined in law but we'd have to look at every particular trade and you don't expect us to do that do you? And I say no you don't, but you can describe the area you're concerned about and you can review trading patterns."
A Shift in the Export Powerhouses
by Floyd Norris
In the first decade of the 21st century, world exports boomed and then fell sharply. And there was a restructuring of the major manufacturing nations of the world. In 1999, the top five exporting countries were the traditional industrial powers — the United States, Germany, Japan, France and Britain. Combined, they accounted for 43 percent of the exports reported by 40 large countries.
As can be seen in the accompanying charts, a new order has emerged. China went from the ninth-largest exporter in 1999 to the largest in 2009. Germany, which passed the United States to become the largest exporter from 2003 to 2008, wound up in second place as the United States fell to third. Britain tumbled to No. 10, from No. 5. All told, the share of exports of the Big Five of 1999 fell to 34 percent in 2009. That loss of nine percentage points was matched by a similar gain for China, India and South Korea, with most of the gain going to China.
Measured in dollars, Chinese exports rose at a compound annual rate of 20 percent through the decade. China even did better than most in 2009, when the combined exports of the 40 large countries fell by 21 percent. China’s dropped by 16 percent that year. Among the top 12 shown in the graphic, the largest declines in 2009 — all of 25 percent or more — were recorded by Japan, Italy and Canada. The United States suffered an 18 percent drop. The 40 countries included in the tally are the largest ones for which figures are available through at least November. Among them, all but Belgium and Spain have reported December numbers. Their figures were estimated based on trends from September to November.
Countries that report figures either annually or quarterly were not included. The largest exporters thus left out are mostly oil exporters, including Saudi Arabia. The figures cover exports of goods, not services. During the decade, American exports rose at a compound rate of a little more than 4 percent. That was far behind China and other emerging Asian exporters like South Korea (10 percent) and India (16 percent). But it was faster than Britain, Canada or Japan.
Those figures are in nominal dollars, not adjusted for inflation. The gains would be different if measured in other currencies, like the euro or yen, but the order would be the same. There are indications of strong rebounds in exports as the world economy begins to recover. In December, American exports were 21 percent above where they had been in the same month of 2008, compared with China’s 18 percent rise. China’s exports were still much larger than those of the United States.
Only a few countries, mostly in Asia, have reported January figures, but some of them showed explosive gains from the depressed levels of early 2009. China’s exports rose 21 percent, but that paled in comparison to the 47 percent gain reported by South Korea and the 77 percent increase in shipments from Taiwan. A significant part of those gains may reflect the need to fill depleted inventories, rather than a surge in consumer demand. It remains to be seen whether world trade can return to the sustained high levels shown from 2003 through 2008, when exports of the 40 countries rose by more than 10 percent every year.
In D.C., more evidence that commercial real estate headed for foreclosure crisis
A mortgage crisis like the one that has devastated homeowners is enveloping the nation's office and retail buildings, and few places are likely to be hit as hard as Washington. The foreclosure wave is likely to swamp many smaller community banks across the country, and many well-known properties, including Washington's Mayflower Hotel and the Boulevard at the Capital Centre in Largo, are at risk, industry analysts say. The new round of financial pain, which some had anticipated but hoped to avoid, now seems all but certain. "There's been an enormous bubble in commercial real estate, and it has to come down," said Elizabeth Warren, chairman of the Congressional Oversight Panel, the watchdog created by Congress to monitor the financial bailout. "There will be significant bankruptcies among developers and significant failures among community banks."
Unlike the largest banks, such as Citigroup and Wachovia, that got into so much trouble early on, the community banks in general fared better in the residential mortgage crisis. But their turn is coming: Not only did community banks issue a higher proportion of commercial loans, but they also have held on to them rather than sell them to other investors. Nearly 3,000 community banks -- 40 percent of the banking system -- have a high proportion of commercial real estate loans relative to their capital, said Warren, whose committee issued a report on commercial real estate last week. "Every dollar they lose in commercial real estate is a dollar they can't use for small businesses," she said. Individuals -- who saw their home values drop in the residential mortgage crisis -- would not feel that kind of loss, but, Warren said, a large-scale failure would "throw sand into the gears of economic recovery."
In Washington, the number of troubled properties has multiplied at a phenomenal rate, with the value growing from only $13 million in 2007 to $40 billion now, according to CoStar Group, a Bethesda real estate research company. The region trails only South Florida and metropolitan New York in the per capita value of commercial real estate assets in foreclosure, default or delinquency, according to the research group Real Capital Analytics. The threat is especially acute in the District, the firm said, where the catalogue of troubled commercial real estate properties has grown tenfold since April. Moreover, the region has $7.3 billion in commercial properties that are underwater -- worth less than the mortgages on them -- according to CoStar.
Whether the commercial real estate bubble bursts in a catastrophic event or subsides slowly and less dangerously will be determined during the next year. An immediate crisis was postponed when domestic and foreign investors began snatching up troubled properties at bargain prices. And banks more and more are renegotiating loans, extending the terms by a year or two in the hope that conditions will improve rather than calling in mortgages that cannot be paid.
In Washington, the office vacancy rate stopped ballooning in the fourth quarter of last year for the first time since the first quarter of 2006, according to CoStar, although largely for an unfortunate reason: The space was being filled mainly by office workers hired to handle the plethora of bankruptcy filings and "workouts" of borrowers who need to renegotiate bad debt. And last quarter, for the first time since the second quarter of 2008, the Washington area office market saw a strong net gain -- 925,000 square feet of space that had been "absorbed" or leased by new tenants, according to CoStar.
"There's light at the end of the tunnel," said Andrew Florance, chief executive of CoStar. "But in commercial real estate it's a very, very long tunnel and many people will not come out of it. Nationwide, at least $1.4 trillion in commercial real estate debt is expected to roll over during the next three years. Warren said that half of commercial real estate mortgages will be underwater by the beginning of 2011. A fifth of residential mortgages are underwater now, she said.
Unlike residential mortgages, which often can be paid over 30 years, commercial real estate mortgages typically must be paid off or refinanced within five years. Commercial properties mortgaged in 2005, 2006 and 2007, at the height of the boom, are reaching their maturity date. "Do the math on this," Warren said. "This is a significant problem." The Renaissance Mayflower Hotel in downtown Washington is unable to meet its debt because of falling room rates, said Frank Innaurato, managing director of the credit-rating firm Realpoint, and the Boulevard at the Capital Centre in Largo, after losing several national retailers, had to extend its $71.5 million bank loan when it matured last fall, according to CoStar.
An office building at 1150 18th St. NW, bought in 2007 for $57.5 million, was sold at foreclosure in December for $21.7 million after losing 25 percent of its tenants, according to CoStar. Even the Mortgage Bankers Association has fallen victim, selling its $90 million Washington headquarters earlier this month for $41 million. Real Capital Analytics and others, however, attribute the surge here largely to Tishman Speyer Properties, which has about 20 D.C. office buildings, according to public records and real estate analysts, and last month walked away from its $5.4 billion Stuyvesant Town and Peter Cooper Village apartments in New York after defaulting on the mortgage.
Now a rival, Brookfield Properties, is buying the company's debt on the D.C. buildings, according to Debtwire, which reports on distressed properties. They include International Square on the 1800 block of I Street NW and several buildings on Pennsylvania Avenue NW. The company, according to the report, defaulted on its loan during the summer. In a statement, Tishman Speyer said it is continuing "discussions with our lender group" on its D.C. area debt. Neither Tishman Speyer nor Brookfield commented on the purported deal.
What happened to Broadway 401, which operates the Dumont on Massachusetts Avenue NW near Fourth Street, has become an all-too-familiar story. In 2006, it borrowed $190 million, constructing two high-rise condominium buildings at the height of the District's real estate boom. But the market crashed, and Broadway wasn't able pay off the loan when it matured in August 2008 because it couldn't sell enough units, according to court filings. About a year later, with the lenders seeking to foreclose, Broadway tried to sell the properties. It gave up after the buildings, appraised at only $140 million, garnered bids ranging from $90 million to $133 million. Finally, last month, Broadway filed for Chapter 11 bankruptcy protection, saying it owed $250 million from its unpaid principal and accrued interest from various loans.
David Weldler, manager of the Broadway properties, did not respond to phone messages seeking comment. In the bankruptcy filing, he said the recession undermined the business plan. "The volume of residential sales has dropped significantly in the U.S., residential prices have declined and credit standards have been tightened, making it considerably more difficult" for buyers to qualify for loans, he wrote. Rockwood Capital, which owns the Mayflower, is in discussions with its lender to modify its loan, Innaurato said. The hotel reduced its rates to maintain occupancy, Innaurato said, and fell behind on payments. "The loan was 30 days delinquent in January 2010," Innaurato said. Officials at Rockwood Capital declined to comment. "They're most likely asking to lower the interest rate or forbearance of payment."
Mark to Make Believe – Still Toxic After All These Years!
by Satyajit Das
In 2007, as the credit crisis commenced, paradoxically, nobody actually defaulted. Outside of sub-prime delinquencies, corporate defaults were at a record low. Instead, investors in high quality (AAA or AA) rated securities, that are unlikely to suffer real losses if held to maturity, faced paper – mark-to-market ("MtM") – losses.
In modern financial markets, market values drive asset values, profits and losses, risk calculations and the value of collateral supporting loans. Accounting standards, both in the U.S.A. and internationally, are now based on theoretically sound market values that are problematic in practice. The standards emerged from the past financial crisis where the use of "historic cost" accounting meant that losses on loans remained undisclosed because they continued to be carried at face value. The standards also reflect the fact that many modern financial instruments (such as derivatives) can only be accounted for in MtM framework.
MtM accounting itself is flawed. There are difficulties in establishing real values of many instruments. It creates volatility in earnings attributable to inefficiencies in markets rather than real changes in financial position.
Alan Greenspan once noted that: "It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations, enhances a person’s ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision-making." He may be the only one qualified to understand modern financial statements.
MtM accounting falls well short of its objective – the provision of accurate, reasonably objective and meaningful information about financial position. In the present crisis, it has heightened uncertainty and confusion about the position of banks and investors.
MtM accounting requires financial instruments to be valued at current market prices. This assumes a market and a price. As Michael Milken (the progenitor of "junk bonds" at Drexel Burnham Lambert) once noted: "Liquidity is an illusion. It is always there when you don’t need it and rarely there when you do."
In volatile times, liquidity becomes concentrated in government bonds, large well known stocks and listed derivatives. For anything that is not liquid, MtM means mark-to-model. This assumes universally accepted pricing methodologies with verifiable inputs. Valuation for all but the simplest instruments today requires a higher degree in a quantitative discipline, a super computer and a vivid imagination. For complex structured securities and exotic derivatives, the only available price is from the bank that originally sold the security to the investor. Prices available from the purveyor of the instrument (a concept known as mark-to-myself) strain reasonable concepts of independence and objectivity.
A current market price of 85% for a AAA security does not actually mean that you will lose 15% of the face value. It is only an estimate of likely losses. It may reflect the opportunity loss of being able to invest in the same or similar security at the time of valuation. In volatile markets, excessive uncertainty or risk aversion means that values deviate significantly from actually cash values.
MtM prices may be prone to manipulation. An often neglected element of the Enron scandal was the company’s ability to convince its auditors and the U.S. Securities and Exchange Commission ("SEC’) to allow MtM accounting to be used in the natural gas industry allowing the company to record current earnings based on the future value of long term contracts.
In dealings with hedge funds and structured investment vehicles ("SIVs"), banks have an incentive to mark positions at high prices thereby preventing complex and illiquid securities being sold at a discount and pushing down prices in the market. If these securities actually traded then the lower market price would have to be used to value positions increasing losses and margin calls on already cash strapped investors.
A lower price can be used to force margin calls and selling that may allow a dealer to buy the assets cheaply. Long Term Capital Management ("LTCM") believed that the dealers brought about their downfall by moving the market values against their positions. In the current credit crisis, at one time markets resorted to barter – you exchange what you want to sell for something else – to avoid recording low prices for securities.
MtM prices, no matter how dubious, drive real investment and credit decisions. Holders of AAA rated securities may be forced to sell securities showing losses because MtM losses reach "stop loss" levels. Where investors have borrowed against these securities, the falling MtM value supporting the borrowing means finding money to top up the collateral or selling the securities thus realizing the loss. In the case of SIVs, the MtM losses trigger breaches of tests that require selling securities to liquidate the structure.
MtM values are used to establish current portfolio values and allow investors to invest or withdraw funds. Errors in pricing lead to transfers in wealth between incoming and outgoing investors; for example, a low value punishes a redeeming investor but rewards the new investor. In 2007, difficulties in establishing MtM values caused some funds to suspend redemptions. Sound investments may be sold off to prevent further losses or realize earnings to cover other losses even where the market does not fairly value the asset penalizing investors.
In the global financial crisis, with the capital markets virtually frozen, the extent of losses on bank inventories of hard-to-value products and commitments (structured debt and leveraged loans) was difficult to establish.
Financial Accounting Standard Board ("FASB") Standard 157 ("FAS157"), which became effective for fiscal years after November 2007, is designed to provide "clarity" to the issue of fair valuation of assets and liabilities.
The centerpiece of FAS157 is the three level hierarchy of valuation (better referred to as the "three levels of enlightenment").
The Fair Value Hierarchy prioritizes the valuation inputs used to determine fair value into:
Level 1 – this requires observable inputs that reflect quoted prices for identical assets or liabilities in active markets and assumes that the entity can access the markets at the measurement date (known as Mark-To-Market). In practice, this means a liquid asset or instrument that is actively traded; for example, where two-way prices are readily available.
Level 2 – this requires inputs other than quoted market prices included within Level 1 that are observable either directly or indirectly (known as Mark-To-Model). In practice, this means instruments that cannot be priced based on trade prices but are valued using observable inputs; for example, comparable assets or instruments or using interest rates/ curves, volatility, correlation, credit spreads etc that can be put through an accepted model to establish values.
Level 3 – this relates to unobservable inputs reflecting the reporting entity’s own assumptions used in pricing an asset or liability (known as Mark-To-Make Believe or Mark-to-Myself). In practice, this means that the asset or liability cannot be priced using observable inputs and requires the use of modeling techniques and substantially subjective assumptions.
FAS157 valuations should be based on the exit price (the price at which it would be sold) regardless of whether the entity plans to hold or sell the asset. FAS157 emphasises that fair value is market-based rather than entity-specific.
FAS157’s fair value hierarchy ranks the quality and reliability of information used to determine fair values – market prices are regarded as reliable valuation inputs, whereas model values that include unobservable inputs are regarded less reliable. The lowest level of significant input drives placement in the hierarchy and the level within the hierarchy drives financial statement disclosures.
The objectives of FAS157 are laudable and unobjectionable. Unfortunately, the standard provides significant discretion to companies in determining the values of assets and liabilities, although detailed disclosure is required. It also may create significant uncertainty in the values of assets and liabilities and financial condition of the reporting entity. This is especially true of Level 3 assets. It is also relevant to the valuation of Level 2 assets.
The problem is compounded by the fact that many major global financial institutions have increased their holdings of Level 3 assets in recent years. Major areas of valuation concern include:
1. Structured finance securities such securitised mortgages including subprime mortgages, securitised credit card obligations, asset backed commercial paper and collateralised debt obligations ("CDOs").
2. Leveraged and private equity loans.
3. Distressed debt.
4. Principal investments by financial institutions in private equity, unlisted securities or physical assets for which there are no true market.
5. Complex derivative contracts including exotic options.
Level 3 assets of the leading 20 U.S. banks as at 31 March 2009 were reported to be $657.5 billion (as reported by the Congressional Oversight Panel in its Oversight Report dated 11 August 2009 "The Continued Risk Of Troubled Assets"). This represented a 14.3 % increase in Level 3 assets compared to three months prior (December 31, 2008). Bank of America, PNC Financial, and Bank of New York Mellon had twice as many assets (in terms of dollars) classified as Level 3 in the first quarter of 2009 compared to year-end 2008. Morgan Stanley had more than ten percent of their total assets categorized as Level 3.
The panel noted that: "The risks troubled assets continue to pose for the banking system depend on how many troubled assets there are. But no one appears to know for certain….It is impossible to ever arrive at an exact dollar amount of troubled assets, but even the challenges of making a reliable estimate are formidable."
The key issue is that a relatively small change in the values of these Level 3 assets has the potential to reduce the capital base of the entity significantly.
The valuation of Level 2 assets may be more problematic than generally assumed especially under condition of market stress. This reflects the impact of model risk and lack of disclosure of the instruments treated as Level 2. Importantly, if market conditions deteriorate then some of these assets classified as Level 2 may need to be reassessed and treated as Level 3 assets.
It is not clear where in the Fair Value Hierarchy specific instruments are currently being valued. The correlation between disclosed bank write-offs and Level 3 assets is imperfect. This may be because individual institutions are classifying assets within the three level hierarchy using different criteria. It may also mean that there is actually no correlation between the classification and "real" losses. The lack of correlation may also reflect behavior, such as new chief executives wishing to write-off assets to be able to "blame" previous management.
Level 3 securities and derivatives cannot be valued using observable prices in liquid public markets. Market values must be based on models and estimates. Where losses are reduced (substantially) by MtM "hedging" gains, the exact nature of the hedges is not disclosed. Some banks and hedge funds have indicated that some losses resulted from hedges that did not function as intended. The hedge counterparty is undisclosed. As the gains are unrealized, if the counterparty (a thinly capitalized hedge fund) is unable to perform, then the hedge gains would be illusory. The lack of disclosure around the value of the hedges, their nature and hedge counterparties makes it difficult to gauge whether they are truly effective in reducing losses.
There are other oddities in current MtM accounting, such as the fair valuation of an entity’s own liabilities. FAS157 and Statement 159 ("Fair Value Option for Financial Assets and Financial Liabilities" issued in February 2007 by the FASB) allows the entity’s own credit risk to be used in establishing the value of its liabilities.
Changes in the entity’s credit standing are therefore reflected as changes in fair value. This results in gains for credit downgrades and losses for credit upgrades. For example, if a bank has $100 million of bonds that are subject to mark-to-market accounting and the market price drops to $80 (80%) then, it records a "gain". As credit spreads increased, U.S. banks have taken substantial profits to earnings from revaluing their own liabilities. These MtM profits on liabilities have helped banks offset recent write-downs. But the revaluation of a bank’s liabilities is problematic. The face value of the liability must still be repaid. The gain from a higher credit spread is unlikely to result in cash profits. It is only if the entity can re-purchase its debt that the "theoretical" gain can be realised.
The Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision objected to Statement 159 prior to its passage. They argued that would the MtM of a bank’s liabilities in this way would "have the contrary effect" of increasing a bank’s net worth at the same time its "financial condition is deteriorating."
The revaluation of a bank’s liabilities may also create volatility of earnings. Major financial institutions have recently been forced to issue substantial amounts of debt to finance "involuntary asset growth" as assets returned onto their balance sheets. This debt has been issued at relatively high credit spreads reflecting current debt market conditions. This means that if the market conditions improve, these institutions may record the mark-to-market losses on their liabilities even as their credit condition improves.
The International Accounting Standards Board ("IASB") is understood to be considering the issue. Under proposals being considered, gains on falls in the value of an issuer’s own debt my no longer be allowed to be recognised. This would remove one of the most controversial elements of MtM accounting.
Trucking failures to accelerate this year
Bankruptcies in the U.S. trucking industry are expected to escalate this year as higher fuel prices and excess capacity squeeze margins further and lenders start to tighten their noose on the sector. The highly fragmented freight market in the United States has been in recession for about three years now. Excess capacity has put pressure on pricing and dented margins at truckers as well as freight brokers. But the sector has not seen as many insolvencies as expected in the last two years, as lenders wait for the market to improve for the used trucks they hold as collateral.
Last year, lenders helped YRC Worldwide (YRCW.O), the No.1 U.S. trucker, narrowly avoid bankruptcy. Industry analysts say a spike in bankruptcies might not be a bad thing after all for the sector -- it will take away hundreds of underperforming companies, suck out the excess capacity and finally narrow the gap between supply and demand. Some of the bigger players in the market, such as J.B. Hunt Transport Services (JBHT.O), Werner Enterprises (WERN.O) and Knight Transportation (KNX.N), are expected to benefit as the insolvency of smaller firms create some breathing space in the sector.
Andy Ahern of consultancy firm Ahern & Associates said he would be surprised if he doesn't see at least 2,500 to 3,000 trucking companies go bankrupt in 2010. According to Ahern, about 2,220 truckers went bankrupt in 2009, compared to 5,500 in 2008. The figures do not include companies that just shut down operations without filing for bankruptcy protection. Even then, this represents a 60 percent decline in bankruptcies in a year when 70 percent of the trucking companies in the market made losses. "We are going to see the collapse of two or three major carriers and that is going to be the beginning of the process of changing supply and demand, and when that happens trucking is going to start to rebound," Ahern said.
Lender leniency has so far stemmed bankruptcies in the trucking industry. Banks have not forced truckers into bankruptcy so far as the current value of used trucks held as collateral is so low that they are worth less than the debt. "Because there is excess capacity, owning a bunch of trucks may not be a great asset at the moment for a bank as collateral," said Drew White of financial information company Sageworks Inc. YRC, which narrowly avoided bankruptcy in December 2009, went through an elaborate debt exchange offer and received concessions from banks and labor union, avoiding a failure that would have changed the supply-demand dynamics in the trucking market.
But analysts don't believe YRC is out of the woods yet. BMO Capital Markets' Jason Granger said YRC could at some point be forced into a position where it needs to significantly downsize its operations and resurface as a smaller organization. Used trucks do not have a strong market as truckers are not adding to their fleet -- they already have a lot of trucks that are not in use due to low freight volumes. "Banks traditionally have become more lenient toward forcing troubled carriers into bankruptcy in early stages of the down cycle," said BMO's Granger. "As asset value that the banks hold as collateral improves, banks start to become more aggressive in forcing carriers into bankruptcy."
He expects the acceleration in bankruptcies to become more pronounced in late 2010 and 2011. Rising fuel prices are another key factor in quickening the pace of bankruptcies. When the benchmark U.S. crude oil prices shot up 47 percent in the first half of 2008, U.S. trucking bankruptcies rose 130 percent, according to analyst Granger. In the last two quarters of 2009, oil prices rose 13 percent. Oil averaged $76 a barrel in the fourth quarter, significantly higher than the $32.40 per barrel touched earlier that year.
Trucking failures are not the only way for excess capacity to leave the market. Some analysts believe mergers and acquisitions could start to see an upside as distressed deals happen and the larger players prepare for a recovery in 2011. Tom Connolly, managing director at Eve Partners, an investment bank focusing on transportation and logistics, said some distressed deals and opportunistic acquisitions could happen, but he doesn't see a dramatic rise in M&As. "I don't think bankruptcy is the only way (for excess capacity to leave the market) but it is the most logical way out," said Connolly.
China Signals Need To Curb Risk Via Prudent Bank Lending
China's banking regulator on Saturday warned banks to "prudently" manage their lending, saying that misuse of loans could hurt the banking sector's stability. In its latest effort to prevent the torrent of bank loans issued since late 2008 from being misused and creating risks to the financial system, the China Banking Regulatory Commission put in place rules, effective immediately, aimed at ensuring loans to individuals and businesses are managed properly. It also required banks to stay vigilant about their lending even after the loans are made.
The two regulations governing loans for working capital and personal loans were first flagged when the CBRC sought public comment during their drafting process last year. But the finalized rules come as policymakers tighten bank lending as risks rise over speculative bubbles in the domestic stock and property markets. "When borrowed funds aren't actually used according to what had been agreed on, it won't just directly affect the borrower's legal rights, but may also spark off systemic risks and affect the stability and security of our banking system," the commission said in statements issued on its Web site.
Given the situation of rapid expansion in credit assets, it has already become a key task for banks and the regulator to ensure the safety of loaned funds and effectively prevent credit risks in their daily operations, said the bank regulator. It warned that the regulator will "strictly pursue responsibility" against financial institutions that don't comply with stringent lending requirements. The CBRC introduced similar regulations for loans on fixed asset investment projects in July. But concerns are intensifying over runaway lending after new yuan loans in January, alone, at CNY1.39 trillion, totaled more than those extended in the last three months of 2009 together. For all of last year, personal consumption loans--mainly housing mortgages--accounted for CNY1.8 trillion, or nearly a fifth of total new yuan lending, likely stoking property prices which have been on the rise in recent months.
Already, Beijing has signaled that it is moving away from its very accommodative credit and monetary policies as the domestic economy recovers. The People's Bank of China has raised the reserve requirement ratio twice since the start of this year, forcing commercial banks to park more of their funds with the central bank in a move that effectively gives them less available funds to lend out. The regulations issued Saturday allow banks to directly issue loans to the borrower's counterparty to ensure the loaned funds are used for their intended purpose. Such an arrangement is intended to "prevent and root out cheating and falsification in the use of borrowed funds," said the bank regulator. Analysts say bank loans have been diverted for investment in the stock market.
Under working capital loans, the lender should also directly issue funds to a borrower's counterparty under certain conditions, including when a payment to the counterparty is huge, the rules say. With the lender's consent, a bank can release the borrowed funds directly to the individual borrower if the loan doesn't exceed CNY300,000, the personal loan rules state. If a personal loan will be used for business and it doesn't exceed CNY500,000, the regulator will also allow banks to release the funds directly to the borrower, a move intended to help individually-run businesses and farmers. The rules aren't intended to make it harder for individuals to borrow from banks, but are meant to prevent banks from extending personal loans for unspecified uses, the regulator said. Working capital loans, in the meantime, cannot be used for production or operation in sectors that the government has banned investment in, the rules say.
China New Village Makes Chanos See Dubai 1,000 Times
The township of Huaxi in the Yangtze River Delta is a proud symbol of how Chinese communists embraced capitalism to lift 300 million people out of poverty during the past three decades. Its leaders took a farm community with bamboo huts and ox carts in the 1970s and transformed it into an industrial and commercial powerhouse where today many of its 30,000 residents live in mansions and most have a car. Per-capita income of 80,000 yuan ($11,700) -- almost four times the national average -- allows Huaxi to claim it’s China’s richest village. Huaxi is also emblematic of the country’s construction and real estate boom. Communist Party officials there are building one of the world’s 30 tallest buildings, a 2.5 billion yuan, 328-meter (1,076-foot) tower.
The revolving restaurant atop the so-called New Village in the Sky offers sweeping views of paddy fields, fish ponds and orchards, Bloomberg Markets reports in its April issue. Marc Faber, publisher of the Gloom, Boom & Doom Report, says China is overdoing it. "It does not make sense for China to build more empty buildings and add to capacities in industries where you already have overcapacity," Faber told Bloomberg Television on Feb. 11. "I think the Chinese economy will decelerate very substantially in 2010 and could even crash." Huaxi has an even more ambitious project coming up: a 6 billion yuan, 538-meter skyscraper that would today rank as the world’s second tallest. The only loftier building is the new Burj Khalifa in Dubai.
Such undertakings figured in warnings hedge fund manager Jim Chanos delivered in January that China is Dubai times a thousand. The costs of wasteful investments in empty offices and shopping malls and in underutilized infrastructure will weigh on China, Chanos, president of New York-based Kynikos Associates Ltd., said in a speech at the London School of Economics. "We may find that that’s what pops the Chinese bubble sooner rather than later." China has defied the global recession of the past two years and remained the fastest-growing major economy. Gross domestic product soared 10.7 percent in the fourth quarter. The government has provided 4 trillion yuan in stimulus spending and encouraged banks to lend a record 9.59 trillion yuan last year, trying to bridge the gap until demand for exports rebounds or domestic consumption takes off.
Last month, banks lent a further 1.39 trillion yuan -- almost one-fifth of the target amount for the whole of 2010. Also in January, foreign direct investment climbed 7.8 percent to $8.13 billion. Retail sales during last week’s Lunar New Year holiday rose 17.2 percent from the same period in 2009, according to the Ministry of Commerce. While China’s resilience has helped support the world economy, raising demand for energy and raw materials, the bursting of a bubble would have the opposite effect. Government efforts to wean the economy off its extraordinary support may roil markets.
In January, the central government ordered banks to curb lending, which put China’s stock market into reverse. In a sign, in part, of how dependent the world has become on China, stocks and currencies slumped in places such as Australia and Brazil that supply commodities to the People’s Republic. On Feb. 12, the eve of the one-week Lunar New Year holiday, China for the second time in a month ordered banks to set aside more deposits as reserves. The Shanghai Composite Index has fallen 8 percent year-to-date, after gaining 80 percent in 2009.
"If the Chinese economy decelerates or crashes, what you have is a disastrous environment for industrial commodities," said Faber, who oversees $300 million at Hong Kong-based Marc Faber Ltd. The stimulus tap that Beijing turned on has flowed to projects such as its 2 trillion yuan high-speed-rail network. The 221 billion yuan Beijing-Shanghai line has surpassed the Three Gorges Dam as the single most expensive engineering project in Chinese history. Some beneficiaries of the government efforts have plowed their loans into real estate and stocks. Property prices across 70 cities jumped 9.5 percent in January from a year earlier, according to government data.
Instead of concentrating on their core businesses, giant state-owned enterprises, or SOEs, have bet on real estate, according to Zhang Xin, a former Goldman Sachs Group Inc. analyst who’s chief executive officer of Soho China Ltd., the biggest property developer in Beijing’s central business district. "All the SOEs are bidding the prices up to the sky," Zhang told China International Business, a magazine backed by China’s Ministry of Commerce, in December. That’s despite office vacancies in China’s capital being at record highs, according to Boston-based commercial real estate company Colliers International.
Chanos, a short-seller who was early to warn about Enron Corp., is one of a growing number of investors sounding the alarm. "Right now, the Chinese market is overheating," George Soros said in a Jan. 28 interview. Local-government officials have wasted stimulus funds by replacing infrastructure that was fine in the first place. State media complained in May 2009 that party chiefs in Jianyang, Sichuan province, decided to help boost the local economy by rebuilding a bridge that was in such good condition it had emerged unscathed a year earlier from the earthquake that killed 70,000 people. The so-called Bridge of Strength withstood a demolition crew that tried to blast it to pieces with dynamite, the official China Daily reported.
Another example Chanos has cited is the city of Ordos, where party officials have built an entire new downtown on the windswept grasslands of Inner Mongolia, 25 kilometers (15 miles) outside the existing municipality of 1.5 million people. Mark Mobius, meanwhile, is sticking with China. The executive chairman of Templeton Asset Management is encouraged that the government is pulling back some of its extraordinary economic support. "We see the government’s tightening of lending as a positive because it moderates the risk to some degree," says Mobius, who oversees $34 billion. "This is a correction in an ongoing bull market."
Chris Ruffle, who helps manage $19 billion for Edinburgh- based Martin Currie Ltd., also remains confident China will avoid a bust. "It’s not a highly leveraged situation," says Ruffle, who works in Shanghai. "I was in Japan in the 1980s, and that was a bubble. Here in China, we are nowhere near that." Still, even Mobius says investors have to be wary. He got rid of an investment in a Chinese food company after discovering that it was using funds to buy apartments instead of to process soybeans.
Judge Rakoff Slams J.P. Morgan Over Loan
A federal judge has rebuked J.P. Morgan Chase & Co. for taking part in an what he called an "end run, if not a down right sham" in the way it arranged a $225 million loan deal for Mexican telecom company Empresas Cablevisión SAB. In a ruling unveiled late last month in U.S. District Court in Manhattan, Judge Jed Rakoff said the New York bank structured the deal so it would have allowed a major competitor of Cablevisión to gain confidential information about the company, which is Mexico's largest cable-television operator.
That competitor, Telmex Internacional SAB, is owned by Mexican billionaire Carlos Slim, who has been fighting off Cablevisión's advances on the Telmex telephone monopoly. Cablevisión itself is a unit of Grupo Televisa SAB, Mexico's largest media giant. The dispute amounts to one of the year's first showdowns between two of the country's most powerful companies. The legal case highlights the breadth of Mr. Slim's Mexican empire, which consists of scores of companies, including those in banking, railways, construction, mining, airlines and hotels. Recently, Mr. Slim has extended that influence into the U.S., including a $250 million investment in New York Times Co.
"J.P. Morgan has been our banker for more than 20 years," said Alfonso de Angoitia, executive vice president of Grupo Televisa, the largest shareholder of Cablevisión, and the largest Spanish-language broadcaster. "We feel betrayed." A J.P. Morgan spokesman declined to comment on the case, citing the pending litigation. In court papers, J.P. Morgan said that it acted in good faith and that its actions wouldn't threaten Cablevisión's trade secrets. Cablevisión's complaint centers on a $225 million loan that J.P. Morgan arranged in 2007 for the purchase of a fiber- optics company. Unable to syndicate the loan to a group of European financial institutions, J.P. Morgan began discussions with the Mr. Slim-controlled Banco Inbursa, to "assign" the loan's obligations and much of its returns to Inbursa. Mr. Slim's son is the bank's chairman.
An Inbursa spokesman didn't answer a request for comment. Mr. Slim couldn't be reached.n Cablevisión objected to assigning the loan to Inbursa, fearing it would give a competitor unfair leverage over its business. J.P. Morgan cut a different deal to hand over 90% of the loan to Inbursa—which didn't require Cablevisión's consent, according to findings of Judge Rakoff. Judge Rakoff ruled that the revised deal, known as a "participation" agreement, essentially amounted to a de facto assignment, which would have required Cablevisión's blessing. "J.P. Morgan, thereby violated at a minimum, the covenant of good faith and fair dealing automatically implied by the law in the credit agreement," he wrote.
The arrangement meant Cablevisión found itself in the curious position of having to hand over restricted information about its business plans to a company affiliated with one of its chief competitors. Judge Rakoff noted that the common ownership of Inbursa and Telmex meant "there is a strong likelihood of irreparable harm arising from Inbursa's ability to seek and obtain Cablevisión's confidential business information." This information included budgets, tallies of capital investments, strategic plans, contract terms for its subscribers and plans for improvements at its growing digital network in Mexico City, a metropolis of 22 million that has become a key battleground between the telecom firms, according to Televisa. Were Cablevisión to deny Inbursa access to documents it requested, the action could trigger a default.
"Inbursa can ask J.P. Morgan to demand virtually any information from Cablevisión that J.P. Morgan is allowed to request under the credit agreement— which is almost anything," wrote Judge Rakoff. Cablevisión presents a serious challenge to Mr. Slim. While he controls 92% of the phone lines in Mexico, Cablevisión and other cable operators have been offering Mexicans phone lines under "triple play contracts," which bundle Internet, cable and telephone lines. Judge Rakoff noted that some of the requirements in the Inbursa loan deal were "unusual" and not included in J.P. Morgan's typical loan deals. Judge Rakoff enjoined J.P. Morgan from continuing to validate its Inbursa loan deal and scheduled further hearings on the matter.
Financial Economics, Deregulation and OTC Derivatives: Interview with Yves Smith
"Wall Street once ran from a graveyard to a river. It now runs from an ocean to an ocean, and beyond. It has become, in Dr. Charles A. Beard's measured words, a new Appian Way of the world. As the Street has changed, the men who rule it have changed, too. Giants of a new breed are in control today, as different from the Vanderbilts and Harrimans and Morgans of the past as the Street is different from the railroad right of way and the bankers' byway it was formerly."
Mystery Men of Wall Street
Blue Ribbon Books, NY (1930)
In this issue of The Institutional Risk Analyst, we feature a conversation with Yves Smith, the nom de plume of the creator of Naked Capitalism and one of the most savvy and respected members of the blogosphere. In professional life Yves is known as Susan Webber and is the founder of Aurora Advisors in New York. She is a graduate of Harvard College and a Baker Scholar and Loeb Fellow graduate of Harvard Business School.
The IRA: Thanks you for taking the time to speak with us today. First tell us about your upcoming book.
Smith: The book is ECONNED: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism and is out next week. It is one of the first books to explain the origins and mechanisms of the financial crisis. It takes a historical sweep, going back to the 1940s and 1950s, which was when the economic discipline made a deliberate effort to become more "scientific" which to them meant more mathematical. This methodological choice favored neoclassical economics and promoted the rise of financial economics whose fundamental flaws were incorrectly dismissed as inconsequential. These faulty ideas nevertheless became the basis of public policy, and led to deregulation in financial services, which in turn produced predation and looting. ECONNED exposes some particularly destructive trading strategies that played a key role in making the crisis much worse than it otherwise would have been, yet have been overlooked by regulators and the press.
The IRA: The economists wanted to mimic the great minds in the world of physics. They figured if the mathematicians could use quantum theory to solve problems of big physics, then why not use the same scientific method to address economic issues. The problem, of course, is that economics involves human behavior, so you cannot use mathematics to describe it. In the February 25, 2010 issue of The New York Review of Books, Freeman Dyson, Professor of Physics Emeritus at the Institute for Advanced Study in Princeton, wrote a wonderful profile of Paul Dirac, who along with Albert Einstein was the father of modern quantum theory. Dirac did not have Einstein's talent for publicity and self-promotion, so few people know of his crucial contribution. Dyson described Dirac's views about the use of mathematics outside of the rational, verifiable world of science in areas such a philosophy. Economics falls into the same social science bucket as philosophy. Dyson writes: "Dirac took no part in these debates and considered them to be meaningless. He said, as Galileo said three hundred years earlier, that mathematics is the language of that nature speaks. When expressed in mathematical equations, the laws of quantum mechanics are clear and unambiguous. Confusion arises from misguided attempts to translate the laws from mathematics to human language." One wonders what Dirac would say today about modern economics.
Smith: Exactly. One of the problems with financial economics is that in order to make the mathematics tractable, economists assume rationality and consistency in human behavior. It is telling that economics is the only social science that makes these assumptions. Every other social science assumes human irrationality and inconsistency. A second problem is that economists prefer a proof-like stylization of their argument, and that further constrains how economists can model real-world behavior. Ironically, mathematicians look down on the way that economists use mathematics.
The IRA: Well they should. In the hard sciences this type of malfeasance and poor methodology choices get you bounced out of the profession, but in economics it is rewarded.
Smith: Yes. So when the economist tries to present his argument in a proof-like style, that methodological choice forces him to assume stability. We all know that is a suspect assumption.
The IRA: So whether we are talking about financial economics or the use of statistical models to predict corporate default or prepayments on mortgage backed securities, the basic assumptions are all wrong and thus the final product is useless. This is, by the way, why we chose to embrace a quarterly survey approach for our bank stress ratings that uses fundamental factors and not statistics. Only by testing each quarter using consistent criteria can you capture the changes in the entire banking industry and individual bank business models.
Smith: Right. That illustrates one of the difficulties of the approaches the discipline prefers, that it makes it hard to integrate qualitative information. "Hard" data that can be quantified easily is preferred, which produces drunk under the street light behavior, of framing empirical analysis around where economists can get clean data, rather than around what questions really are important to be answered, and then figuring out how to get insight with the information, both hard and soft, that is available.
The IRA: Correct, thus we have the spectacle of efficient market theory reliant upon equity market prices to predict default. This brings us to the luncheon discussion we had with Nouriel Roubini last week and our favorite topic, namely credit default swaps (CDS). We have always seen CDS and OTC derivatives in legal terms as an outgrowth of the market for currencies and interest rates. When OTC swaps were just about currencies and interest rates or even energy, there really was no problem because these contracts are priced against visible, liquid cash markets. But when the banks went into credit products, in our view at least, they went a bridge too far because there is no cash basis for the derivative. Instead the banks use models that were developed by financial economists in partnership with the large banks. Indeed, if you think of CDS as the creation of an ersatz, speculative market such as trading carbon credits, it fits very nicely with your description of the speculative nature of financial economics. What is your view of the evolution of CDS?
Smith: People use the term "swap" for CDS, but things like credit contracts or carbon trading markets are at best prediction markets. The whole use of the term swap is a misnomer. There is a great fondness for prediction markets, but they can and do perform badly. It really comes down to whether the people making the bets are making informed judgments. I'm sure you've heard your clients complain like mine that the marginal price of these instruments are being made by a 24 year old who knows nothing about the underlying relationships. The CDS market is almost entirely divorced from old fashioned credit analysis and, indeed, the participants basically say that if CDS says X, why do I need to do credit analysis?
The IRA: Precisely. We see numerous examples in the academic literature where economists take CDS prices as biblical text and rely on these contracts to support research. The profession is effectively eating its own tail, but they don't seem to appreciate such distinctions. If you look at the Bloomberg or any of the other commercially available models to calculate probability of default, the reality is that the users are simply pricing off volatility, not any thoughtful measure of default risk. At lunch last week you started to talk about Phibro-Salomon and the competitive issues which drove the evolution of CDS at the largest banks. Care to expand?
Smith: There was a very interesting bit of industry evolution which led to the creation of the swaps market. People forget history. Back in the 1960s, over 70% of securities industry revenue was from commissions on equities. Firms held very small inventories. Institutional investors held longer dated Treasury and corporate debt to manage the fixed liabilities in their portfolio. Because pension funds and life insurers matched assets against exposures, bonds did not trade very much in the secondary market. The interest rate environment was stable and people were fairly confident in their ability to forecast. In the newly volatile interest rate environment of the 1970s, you suddenly saw a shift to bond trading. This was also the period of deregulation of stock brokerage commissions, so you saw the safe businesses squeezed. These changes in the business environment drove an increase in trading of instruments and this forced dealers to increase their inventory to accommodate trading and began to put pressure on the old line partnerships. It meant they needed bigger balance sheets, hence more equity, when revenues were falling and risks were rising.
The IRA: Correct. We saw that working at Bear, Stearns in the 1980s. They could not handle the huge leverage structure that rested on top of their capital position. Indeed, if you look at the banks that we cover today in the IRA Advisory Service, names such as Goldman Sachs (GS) and Deutsche Bank (DB) are heavily reliant on trading revenue. In the case of DB, the bank's primary business line is now cash and derivatives trading out of their London operation. So did deregulation cause the financial crisis of 2007? This sounds like yet another case in point where efficiency is not necessarily a good thing. When we deregulated Wall Street, did we force the banks to become more speculative?
Smith: I don't think that anybody thought through the implications. Deregulation was seen as benign. All of the measures that the SEC took to wring more easy profits out of the industry were justified in the name of helping the little guy, the small investor. We went from trading stocks on eighths to decimalization. But while deregulation was justified as being pro-consumer, the results do not bear this out. Look at the unintended consequences. The average holding period for stocks has dropped dramatically. It used to be something like 22 months, now it is well below a year. "Investors" can no longer be considered to be investors anymore.
The IRA: No, they are speculators. This is the Jim Cramer, CNBC school of day trading as "investing." And this also goes to your point about the speculative nature of financial economics.
Smith: Exactly. Along with the changes in the markets and the behavior of individual investors, you had growing pressure on banks to generate profits and expand their balance sheets. Salomon Brothers responded by selling out to Phibro, a publicly traded commodities dealer, to gain access to cheaper capital in 1981. As the inflation-stoked commodities boom became a bust almost immediately after the deal closed, the old Salomon partners engineered a bit of a coup and came out on top. This was during the explosive period of growth in the mortgage-backed securities market, a very profitable business which Salomon pioneered. Salomon made more money in the mid 1980s than all of the other major firms combined. This freaked-out their competitors. Salomon was aggressively building out its platform internationally and this infrastructure expansion also put a lot of pressure on other firms. The economics of the traditional partnerships with higher cost of capital could not accommodate these demands. By 1986, all the full-line investment banks were public firms, with the lone exception was Goldman Sachs because they took an investment from Sumitomo Bank.The IRA: And of course you worked for both firms during this period.
Smith: Yes. The second wave of pressure on investment banks came with the rapid growth of the OTC derivatives in the early 1990s. That business favored commercial banks with bigger balance sheets and this gave the commercial banks the chance to get in on the ground floor. The commercial banks had been pecking away at getting into the old-style investment banking business during the 1980s and had not made much progress. OTC derivatives was a market where the commercial banks had an advantage. They could get into the business using quants trained in the world of financial economics, a lot of them acquired via acquisitions of teams or established firms. So, again, the investment banks were forced to bulk up even further and acquire more capital.
The IRA: This suggests one of our favorite topics, which is that efficiency is not always good. The founders of the United States rejected efficiency arguments and instead used mechanisms such as checks and balances to deliberately make our political system inefficient, but the financial economists took the nonsense of efficient market theory to its most extreme.
Smith: Correct. The policies that came out of the Great Depression, which policy makers thought about carefully, were successful until the environment changed radically. We had forty years of stability on Wall Street under the rules established in the 1930s. Commercial banks were kept stupid and comfortably profitable, but that approach depended on there being little volatility. The old rule of 3-6-3, gather deposits a 3%, lend a 6% and the bank officer leaves as 3:00 in the afternoon was the model and it worked well.
The IRA: That is the description of a community bank today. They have a couple of funding choices and can perhaps go the Federal Home Loan Banks, but that's about it. But all banks are about to get to know the old boogie man of interest rate risk when the Fed ends its asset purchases next months. Our friend and mentor Martin Mayer likens the evolution of the OTC markets as a pre-1930s bucket shop model, a completely speculative model. Do you agree with that characterization?
Smith: That isn't too far off the mark. The new behemoth capital markets players really saw the role of traditional investment and commercial bankers eroded, so the new culture is a trading culture. The concerns on the investment banking side had acted as somewhat of a check on behavior. Branding and reputation matters to bankers, so you can't be seen to be ripping off your clients. Now with the trading side ascendant at most firms, the attitude is that anything goes and all fair in love and war. This has resulted in a predatory posture by most firms toward their clients. If trading is all that matters and you are not concerned about traders and the sales desk killing the goose that laid the golden egg in terms of buy side clients, then you end up with situations like the one destroyed Bankers Trust. Proctor & Gamble sued them in a dispute over P&G's losses, and got access to taped conversations by BT's staff. The comments about clients became public and they contained incredibly damaging material, remarks like "We lure them into the dark and fuck them." That attitude has become common today. The only difference is that people in the industry today haven't been caught talking about it the way the Bankers Trust did.
The IRA: There was a little bit of reporting on this in the New York Times recently, talking about the difference between a sales person and an investment adviser. The former has no duty of care to the institutional client while the latter has an affirmative duty to follow rules on suitability and know-your-customer. Do you think that the SEC should revisit this issue and consider imposing a duty of care on all employees of banks and dealers?
Smith: Yes, because then you would have grounds for private lawsuits.
The IRA: Correct. Such a regime would also imply an end to FINRA arbitration to hide the bad acts so that investors could sue dealer firms for fraud and negligence when the duty of care was not performed. People often forget that there are many former employees of dealers who now work in the hedge fund community, including some very prominent names and owners of funds, who cannot be registered with FINRA because of previous transgressions.
The IRA: What do we do to fix this problem? Other than imposing suitability and a duty of care by the employees of dealers, what else would you do to lessen the speculative character of the financial markets?
Smith: I would subject everything to SEC disclosure standards. One of my pet peeves is significant omissions in disclosure. For example, one of the things that the FDIC is pushing in its proposed changes for securitization rules is that the parties very clearly disclose their intent. Under the current rules, you cannot determine who intended to do what in a given transaction. Whoops! The underwriter of a securitization is using the vehicle to go short? Most investors would give a deal a lot more scrutiny if they knew that to be the case. Goldman's Abacus and Deutsche Bank's Start programs were each a series of synthetic CDOs that the firms used to put on real estate shorts. Most people think those deals did not pass the smell test; indeed, Bear Stearns refused to work with John Paulson when he wanted to create synthetic CDOs for the same purpose, to go short. But that sort of arrangement is kosher under the current rules. That's the sort of thing the FDIC wants to change. They would require the Paulsons, Goldmans and Deutsches to explain their true aims.
The IRA: Would you require that holders of CDS be compelled to deliver the underlying asset in order to receive payments on their default insurance? This would essentially take us back to the pre-Delphi world.
Smith: That would make a huge difference. I do not understand a world in which you can change the rules on existing contracts, as the industry did to preserve the CDS market when Delphi declared bankruptcy, on the one hand, but then rail about the sanctity of contracts on the other. All CDS prior to Delphi required that you present the bond to the protection seller, who would then pay you the face amount that he had guaranteed. Suddenly ISDA discovers in Delphi, the first real test of the CDS market, that the notional value of the contracts on Delphi greatly exceeds the face amount of outstanding bonds. Rather than risk the credibility of a product that was a big profit engine for its members, it modified the rules on the fly to allow for cash settlement. And that has allowed for a lot of destructive behavior, particularly the role that shorting subprime played in the crisis. It allowed the amount of subprime exposure to become much greater than that of the actual subprime market, greatly increasing the amount of damage done to financial institutions and costs to taxpayers.
The IRA: Well, this is the dirty secret about Paul Volcker and Gerry Corrigan. As regulators each of these men stood by and watched all of these developments in the banking industry and did nothing. Indeed, each of them encouraged these evil evolutions in order to boost the short-term profitability of the large banks but never understood or cared that on a risk-adjusted basis these returns were in fact negative.
Smith: One thing that has been disappointing is that here we are, approaching three years since the start of the crisis, and there have been no investigations of fraud on Wall Street. Lehman was clearly a fraud. Hank Paulson effectively says that in his new book, that Lehman had greatly overvalued its assets in its SEC filings. Some argue that we should not pursue fraud claims with respect to Lehman because that would complicate the bankruptcy. That is not a good enough reason because who knows where a thorough investigation would lead. The other part that I find disappointing is that people keep talking about banks, but don't differentiate between ones those with dealer operations and those without. None of the reform proposals on the table now, including the Volcker rule, deal with this distinction. Trading and market-making operations pose very different sets of risks, both to the institution itself and to the financial system than traditional banking, and therefore need to be addressed differently.
The IRA. We could not agree more. Thanks Yves and good luck on the book.