"Guests of trailer park enjoying the sun and sea breeze at the beach, Sarasota, Florida"
Ilargi: Today we have a guest contribution from one of our regular commenters, El Gallinazo, who weighs in on the dead horse of inflation vs. deflation, dissecting a John Williams Shadowstats paper. And while Stoneleigh and I here at The Automatic Earth haven't had any doubts on the issue in "like forever", keeping the discussion alive in some form may be useful, if only simply since it won't go away.
Just let me state two issues that are obvious to us before handing you over to the cantankerous vulture:
- There is no way we'll get into hyperinflation BEFORE debt deflation has run its course.
- There is no way the Federal Reserve (or ECB, Bank of Japan) can print enough money, electronically or physically, to fabricate hyperinflation, as long as the debt deflation train hasn't finished running over our economic systems.
- After that train is done, it's anybody's guess; the damage done will be so severe there may not be a Fed left to inflate even a party balloon.
El Gallinazo: Beating the Dead Horse (again)
Everyone with three functional synapses and an opposable thumb knows that we are headed into a second great depression. Optimizing survival strategies for anyone lucky enough to have any assets really boils down to the question of deflation versus hyperinflation, or a sequential mixture of the two. Most of the hyperinflationistas are morons, even the ones that don't have a faux Nobel. So it was a pleasure when a commenter at The Automatic Earth tipped me off to John Williams' -relatively- recent paper:
Hyperinflation Special Report (Update 2010)
Even my cantankerous self wouldn't dare to call Williams a moron. So here we have three hyper-intelligent people with three different viewpoints on the subject.
- Robert Prechter: Depression with giant deflation. Cash is king. Inflation nowhere in sight.
- Stoneleigh (as well as Ilargi) at The Automatic Earth: Same as Prechter but with the caveat that when nearly all credit disappears and globalized markets cease, then hyperinflation is likely to kick in. As to a timeline of transition from deflation to hyperinflation, Stoneleigh recently indicated 2 to 5 years.
- John Williams : Like the two above, he also predicts a great depression with deflation as the immediate outcome. However, Williams differs in that he claims that the deflation will be very short lived, a matter of months, and will morph quickly into hyperinflation.
A possible answer to this quandary can be approached by posing the two following questions:
- Would the Fed ever want hyperinflation?
- If so, is the Fed capable of instituting it?
Well, the vote breaks down as the following (as far as I can figure):
Both 1) & 2): Prechter and Stoneleigh - no; Williams - yes.
Prechter is quite clear that the Fed would never want hyperinflation and even if it did, it is quite incapable of pulling it off. Stoneleigh has not really weighed in on whether the Fed would ever want hyperinflation, but she is quite clear that until deleveraging is complete, that the Fed is incapable of instituting it. By that time, the Fed may not exist at all and would certainly be quite different than it is today. Williams has claimed that the Fed has wanted inflation since its inception in 1913, and is quite capable of pulling it off.
Well, I am going to weigh in with some opinions now. Williams defines hyperinflation far more severely than I would. He defines it as inflation that is so severe that the money is worth less than the fabric which it is printed on in a matter of months, and people use it as kindling and rather unhygienic bathroom tissue. In this regard, I would imagine uncirculated bills might fetch a certain premium due to their cleanliness.
Williams claims that hyperinflation is the only way out of the debt trap other than default on treasuries and unfunded obligations. It never seems to occur to Williams that since most unfunded obligations, such as Social Security and Medicare / Medicaid are owed to the helpless and the pissants, as long as NORTHCOM can prevent said pissants from stringing them up to the nearest lamppost, the oligarchs would have little remorse on reneging on these unfunded obligations.
Prechter points out that the Fed is the ultimate narcissistic institution and always does what is best for the Fed. And hyperinflation would be the Fed committing suicide. If they destroy all value whatsoever to the USD, the Fed is quite out of business.
Furthermore, Williams keeps writing about foreign investors losing confidence in the dollar and dumping them. But he never says how. In a river? Buying gold, Euros, land, oil futures, pork bellies? How are these guys going to dump their dollars? He is very bullish on the Canadian dollar and the Swiss Franc. But UBS, which is in deep doodoo, is 8 times the size of the whole country of Switzerland, and Canada is in a bigger (soon to pop) real estate bubble than the US. Williams almost totally ignores credit and does totally ignore the shadow banking system, which is in a slow motion train wreck. If I had to choose the biggest fault in his argument, that would be it.
In the exciting climax section to his essay, subtitled "Hyperinflationary Great Depression", he does deal in some depth with some of the problems which the Fed would face instituting hyperinflation. He claims that after the crash, remaining cash would disappear and we would immediately enter a poorly organized barter system. He admits that there are probably about $400 billion in greenbacks in potential circulation inside the USA now, and he doesn't explain why they would either disappear or become worthless. While $400 billion is not going to run our economy normally, to say the least, it will buy quite a few eggs and radishes at depressed prices. He seems to be confusing FRN's with stuff like demand deposits. How is the cash going to disappear and how does it become worth less as demand deposits disappear through banks collapsing? One would assume this is a perfect scenario for cash as king, as in Great Depression v. 1.0.
Williams does build a strong case that the Fed has wanted inflation from its inception. But there is a huge difference between inflation and hyperinflation. The former is quite useful in extracting the wealth from the peasants and funneling it upward to their betters, but the latter is, quite obviously, the final debt rattle of the whole financial system. Williams does not distinguish between them. Not all con artists are suicide bombers.
Williams also fails to deal with exactly how Uncle Ben is going to pump a gazillion dollars into the economy with any velocity. He admits that doing it electronically is problematic as by then most of the people will have lost their credit card accounts. Printing it and dropping it from helicopters as Uncles Miltie and Ben have suggested also doesn't seem to fill the bill. Squirrels and birds would feather their nests with them.
Then he writes about runs on the banks and how the Fed would fly cash, hot off the press, into banks that were being run on. Even if this were to happen, which I doubt would last more than a few days in a systemic banking collapse, it would not be hyperinflationary as the Fed would just be replacing checking account credit, that had absconded to money heaven, with paper. In terms of the total credit and money supply, it would just be a push in Vegas vernacular.
Well folks, just read this final section for yourselves. If Williams were a mystery novelist, the critics would totally pan him for not pulling all the strings together at the conclusion. It's more like he builds a really strong case for mega deflation, pulls a magic wand out of his back pocket, makes a few passes with appropriate sounds ...... and puff - hyperinflation. Well, read it for yourself, and comment.
I enjoyed the essay, however, as it got my tiny 125cc, single cylinder brain firing at high rpm's, but as to the substance of the work, he just doesn't pull it together. Brings me back to my science days, when a researcher's data point to conclusion A, but the guy is totally invested in B, so somehow he twists the data to support B in a final paroxysm of cognitive dissonance.
As a counterpoint of sorts, I would like to point to another article, this on Zero Hedge by Doug Hornig, titled The Big Dead-Cat Bounce
Much shorter and well worth reading. Toward the end, Hornig writes:
"That means it’s likely, in the not_too_distant_future, that the government will be confronted with a very stark choice between defaulting on the debt or trying to inflate its way out. The former would kill off economic growth and likely launch a worldwide depression of epic proportions.
Disastrous as that would be, if the alternative is chosen and Washington’s printing presses beget hyperinflation, that would probably be worse. In a serious deflation, those who have saved for a rainy day can make it through okay. In hyperinflation, which unconstrained further spending could easily bring on, everyone loses. The truly prudent prepare, as best they can, for either eventuality."
(Well, that's exactly what I am doing by investing in Reverend Billy's Passbook to Heaven account. God is the ultimate hedge.)
What is interesting about this quote is that Hornig poses the question of hyperinflation or deflation as a very conscious political choice on the part of the oligarchs. Weimar chose hyperinflation out of revenge to screw the French. "You want blood money? Well here it is and you can wipe your butts with it." Uncle Ben doesn't strike me as a suicide bomber. When he lies in state, he expects his beard still to be immaculately groomed.
Below, for what it’s worth, are some of the notes and page references which I made when reading Williams’ article.
- Williams defines inflation and deflation in terms of prices and not the change in the sum of money credit and velocity. p 5
- However, he implicitly recognizes the Automatic Earth definition with: "Importantly, a sharp decline in broad money supply is a prerequisite to goods and services price deflation." p 21
- Using Williams's CPI, I calculated that the real rate of average price increases since 1982 averaged 13% a year. This would be what the MSM refers to as "inflation." Williams strongest asset is as a statistician who corrects BLS bullshit vis-a-vis the CPI and unemployment.
- Williams states that his adjusted CPI never fell below 5% rate of change since the financial crises while the BLS CPI went negative. I wonder how his statistics deal with the value of residential and commercial real estate collapse? This is a huge deflationary pressure either by price or money supply definitions. p 16
- For full disclosure, Williams states that he is a conservative Republican of the Libertarian wing. p 17
- Williams states that the actual federal deficit is currently at $9 trillion a year. I wonder exactly how he arrived at that figure? p 18
- Williams keeps repeating the phrase "dumping of dollars and dollar denominated assets" yet he does not define the other side of the trade. Real estate? Gold? Euros? Swiss Francs? Pork bellies? While Williams admits that the dollar has "soared" since the start of the financial crises, he writes this off to central bank manipulation, but offers no meaningful evidence. Seems contradictory. He repeats like a broken record that Bernanke wants to castrate the dollar, yet here, the central banks, of which the Fed is chairman of the board, suddenly gets into a huge manipulation to strengthen it on the forex markets. Hmm.... p 26
- "(2) Includes gross federal debt, not non_public debt is debt the government owes to itself for Social Security, etc., the obligations there are counted as "funded" and as such are part of total government obligations." p 29.
Is this correct? My understanding was that the Social Security Trust Fund was part of the $12T current public debt.
Michael Lewis: Wall Street Collapse A Story Of 'Mass Delusion'
It may be tempting to think Wall Street is full of criminals who got off easy during the financial crisis. But bestselling author Michael Lewis cautions against such an easy conclusion. "I think the story is much more interesting than that," he said during an interview on CBS's 60 Minutes. "I think it's a story of mass delusion."
The former bond trader is releasing a book this week called The Big Short: Inside the Doomsday Machine. According to CBS, the result of his 18-month investigation attempts to explain, "how some of Wall Street's finest minds managed to destroy $1.75 trillion of wealth in the subprime mortgage markets."
Lewis told the network, "The incentives for people on Wall Street got so screwed up, that the people who worked there became blinded to their own long term interests. And because the short term interests were so overpowering. And so they behaved in ways that were antithetical to their own long term interests."
WATCH PART ONE:
WATCH PART TWO:
Goldman Sachs derivative liability = 33,823% of assets
I have spoken at length here about the insidiousness of derivatives and Credit Default Swaps. So this new statistical reference frankly awed me. It is from a Levy paper on the recent shift over the last 50 years to a shadow banking system, that has largely replaced bank balance sheet lending with Money Managers. As I read this paper, while I am also reading ‘This Time is Different – eight centuries of financial folly’, there is little to feel good about in the apparent economic rebound that the government keeps telling us about.The data on derivatives is impressive. JPMorgan Chase, for example, held derivatives worth 6,072 percent of its assets at the peak of the bubble in 2007. The other two giants, Citigroup and Bank of America, although still far behind Chase, had 2,022 percent and 2,486 percent respectively. Goldman Sachs, the other giant, had an astonishing amount of derivatives on its balance sheets: 25,284 percent of assets in 2008 and 33,823 percent as of June 2009. Citigroup and BOA now have more of this risk on their books than before the crisis (FDIC SDI database).
The part that awed me, is that BofA and Citi now have more derivative exposure than they did in 2007! Huh! What is Timothy Geithner being paid for? I have to admit after TARP and the apparent hands on approach I like most assumed things were being fixed, but apparently not.
This simply adds to the point that despite all the histrionics and efforts in Washington, nothing has been learned and the American Banking system is now at least at as much risk now as in 2007, pre crash.
Incidentally when trying to understand derivatives, simply assume off balance sheet debt. There is all kind of rationale as to why that off balance sheet debt is not dollar for dollar, but the important point is that no-one argues that derivatives are worth zero. There is an intrinsic liability that frankly few bankers can explain to you, so you must begin with the face value of the liability, and banks are guilty until proven innocent on that one.
As an accountant, the notion of off balance sheet debt is a contradiction in terms. Is it a liability? If yes, it should be on the balance sheet.
Goldman Sachs Demands Collateral It Won’t Dish Out
Goldman Sachs Group Inc. and JPMorgan Chase & Co., two of the biggest traders of over-the- counter derivatives, are exploiting their growing clout in that market to secure cheap funding in addition to billions in revenue from the business. Both New York-based banks are demanding unequal arrangements with hedge-fund firms, forcing them to post more cash collateral to offset risks on trades while putting up less on their own wagers. At the end of December this imbalance furnished Goldman Sachs with $110 billion, according to a filing. That’s money it can reinvest in higher-yielding assets.
"If you’re seen as a major player and you have a product that people can’t get elsewhere, you have the negotiating power," said Richard Lindsey, a former director of market regulation at the U.S. Securities and Exchange Commission who ran the prime brokerage unit at Bear Stearns Cos. from 1999 to 2006. "Goldman and a handful of other banks are the places where people can get over-the-counter products today."
The collapse of American International Group Inc. in 2008 was hastened by the insurer’s inability to meet $20 billion in collateral demands after its credit-default swaps lost value and its credit rating was lowered, Treasury Secretary Timothy F. Geithner, president of the Federal Reserve Bank of New York at the time of the bailout, testified on Jan. 27. Goldman Sachs was among AIG’s biggest counterparties. Goldman Sachs Chief Financial Officer David Viniar has said that his firm’s stringent collateral agreements would have helped protect the firm against a default by AIG. Instead, a $182.3 billion taxpayer bailout of AIG ensured that Goldman Sachs and others were repaid in full.
Over the last three years, Goldman Sachs has extracted more collateral from counterparties in the $605 trillion over-the- counter derivatives markets, according to filings with the SEC. The firm led by Chief Executive Officer Lloyd C. Blankfein collected cash collateral that represented 57 percent of outstanding over-the-counter derivatives assets as of December 2009, while it posted just 16 percent on liabilities, the firm said in a filing this month. That gap has widened from rates of 45 percent versus 18 percent in 2008 and 32 percent versus 19 percent in 2007, company filings show.
"That’s classic collateral arbitrage," said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York who previously worked as treasurer at Morgan Stanley and chief financial officer at Lehman Brothers Holdings Inc. "You always want to enter into something where you’re getting more collateral in than what you’re putting out." The banks get to use the cash collateral, said Robert Claassen, a Palo Alto, California-based partner in the corporate and capital markets practice at law firm Paul, Hastings, Janofsky & Walker LLP. "They do have to pay interest on it, usually at the fed funds rate, but that’s a low rate," Claassen said.
Goldman Sachs’s $110 billion net collateral balance in December was almost three times the amount it had attracted from depositors at its regulated bank subsidiaries. The collateral could earn the bank an annual return of $439 million, assuming it’s financed at the current fed funds effective rate of 0.15 percent and that half is reinvested at the same rate and half in two-year Treasury notes yielding 0.948 percent. "We manage our collateral arrangements as part of our overall risk-management discipline and not as a driver of profits," said Michael DuVally, a spokesman for Goldman Sachs. He said that Bloomberg’s estimates of the firm’s potential returns on collateral were "flawed" and declined to provide further explanation.
JPMorgan received cash collateral equal to 57 percent of the fair value of its derivatives receivables after accounting for offsetting positions, according to data contained in the firm’s most recent annual filing. It posted collateral equal to 45 percent of the comparable payables, leaving it with a $37 billion net cash collateral balance, the filing shows. In 2008 the cash collateral received by JPMorgan made up 47 percent of derivative assets, while the amount posted was 37 percent of liabilities. The percentages were 47 percent and 26 percent in 2007, according to data in company filings. "JPMorgan now requires more collateral from its counterparties" on derivatives, David Trone, an analyst at Macquarie Group Ltd., wrote in a note to investors following a meeting with Jes Staley, chief executive officer of JPMorgan’s investment bank.
By contrast, New York-based Citigroup Inc., a bank that’s 27 percent owned by the U.S. government, paid out $11 billion more in collateral on over-the-counter derivatives than it collected at the end of 2009, a company filing shows. The five biggest U.S. commercial banks in the derivatives market -- JPMorgan, Goldman Sachs, Bank of America Corp., Citigroup and Wells Fargo & Co. -- account for 97 percent of the notional value of derivatives held in the banking industry, according to the Office of the Comptroller of the Currency. In credit-default swaps, the world’s five biggest dealers are JPMorgan, Goldman Sachs, Morgan Stanley, Frankfurt-based Deutsche Bank AG and London-based Barclays Plc, according to a report by Deutsche Bank Research that cited the European Central Bank and filings with the SEC.
Goldman Sachs and JPMorgan had combined revenue of $29.1 billion from trading derivatives and cash securities in the first nine months of 2009, according to Federal Reserve reports. The U.S. Congress is considering bills that would require more derivatives deals be processed through clearinghouses, privately owned third parties that guarantee transactions and keep track of collateral and margin. A clearinghouse that includes both banks and hedge funds would erode the banks’ collateral balances, said Kevin McPartland, a senior analyst at research firm Tabb Group in New York.
When contracts are negotiated between two parties, collateral arrangements are determined by the relative credit ratings of the two companies and other factors in the relationship, such as how much trading a fund does with a bank, McPartland said. When trades are cleared, the requirements have "nothing to do with credit so much as the mark-to-market value of your current net position." "Once you’re able to use a clearinghouse, presumably everyone’s on a level playing field," he said.
Still, banks may maintain their advantage in parts of the market that aren’t standardized or liquid enough for clearing, McPartland said. JPMorgan CEO Jamie Dimon and Goldman Sachs’s Blankfein both told the Financial Crisis Inquiry Commission in January that they support central clearing for all standardized over-the-counter derivatives. "The percentage of products that are suitable for central clearing is relatively small in comparison to the entire OTC derivatives market," McPartland said.
A report this month by the New York-based International Swaps & Derivatives Association found that 84 percent of collateral agreements are bilateral, meaning collateral is exchanged in two directions.
Banks have an advantage in dealing with asset managers because they can require collateral when initiating a trade, sometimes amounting to as much as 20 percent of the notional value, said Craig Stein, a partner at law firm Schulte Roth & Zabel LLP in New York who represents hedge-fund clients.
JPMorgan’s filing shows that these initiation amounts provided the firm with about $11 billion of its $37.4 billion net collateral balance at the end of December, down from about $22 billion a year earlier and $17 billion at the end of 2007. Goldman Sachs doesn’t break out that category. A bank’s net collateral balance doesn’t get included in its capital calculations and has to be held in liquid products because it can change quickly, according to an executive at one of the biggest U.S. banks who declined to be identified because he wasn’t authorized to speak publicly.
Counterparties demanding collateral helped speed the collapse of Bear Stearns and Lehman Brothers, according to a New York Fed report published in January. Those that had posted collateral with Lehman were often in the same position as unsecured creditors when they tried to recover funds from the bankrupt firm, the report said. "When the collateral is posted to a derivatives dealer like Goldman or any of the others, those funds are not segregated, which means that the dealer bank gets to use them to finance itself," said Darrell Duffie, a professor of finance at Stanford University in Palo Alto. "That’s all fine until a crisis comes along and counterparties pull back and the money that dealer banks thought they had disappears."
While some hedge-fund firms have pushed for banks to put up more cash after the collapse of Lehman Brothers, Goldman Sachs and other survivors of the credit crisis have benefited from the drop in competition. "When the crisis started developing, I definitely thought it was going to be an opportunity for our fund clients to make some headway in negotiating, and actually the exact opposite has happened," said Schulte Roth’s Stein. "Post-financial crisis, I’ve definitely seen a greater push back on their side." Hedge-fund firms that don’t have the negotiating power to strike two-way collateral agreements with banks have more to gain from a clearinghouse than those that do, said Stein.
Regulators should encourage banks to post more collateral to their counterparties to lower the impact of a single bank’s failure, according to the January New York Fed report. Pressure from regulators and a move to greater use of clearinghouses may mean the banks’ advantage has peaked. "Before the financial crisis, collateral was very unevenly demanded and somewhat insufficiently demanded," Stanford’s Duffie said. A clearinghouse "should reduce the asymmetry and raise the total amount of collateral."
Money can't buy you happiness, economists find
Inhabitants of wealthy countries tend to grow more miserable as their economy grows richer, according to research. Economists Curtis Eaton and Mukesh Eswaran found that while the richest people, such as footballers and bankers, could perk themselves up with a new pair of designer shoes or a sophisticated mobile phone. However, the bulk of the population who were unable to afford the latest status symbols were left unhappier by their inability to keep up.
As countries become wealthier, more value is attached to objects which are not strictly necessary for comfortable living, the researchers claim. People are then drawn into keeping up with the Joneses which results in less happiness for those who cannot afford the newest "must-have" items even if their wealth has increased. The nation’s sense of "community and trust" can then be damaged which, in turn, can affect the wider economy, the experts argued.
Prof Eaton, of the University of Calgary, and Prof Eswaran, of the University of British Columbia, concluded that, beyond the point of reasonable affluence, greater riches can make a nation collectively worse off. In their research, published in the Economic Journal, they said: "These goods represent a 'zero-sum game' for society: they satisfy the owners, making them appear wealthy, but everyone else is left feeling worse off. "Conspicuous consumption can have an impact not only on people's well-being but also on the growth prospects of the economy." The Canadian research follows in the footsteps of the 19th century Norwegian-American economist Thorstein Veblen. Prof Veblen coined the term "conspicuous consumption" and said it was a method by which people seek to set themselves apart.
Loan Squeeze Thwarts US Small-Business Revival
Thomas Harrison, chief executive of Michigan Ladder Co., has a plan that would contribute to the U.S. economic recovery: Expand the 108-year-old company, adding at least 20 jobs in the process. His chances of getting the loan of $300,000 or more he needs to do so, though, depend in part on what happens to folks like home builder James Haeussler. Both are customers of the same community bank, the Bank of Ann Arbor. Mr. Haeussler is struggling to repay $8.3 million he and a partner borrowed to build a residential community in nearby Saline, Mich. In this economic environment, the bank doesn't want to take a chance on what it sees as a risky new loan to Mr. Harrison.
"In a world where Jim Haeussler makes it, Tom Harrison will make it," says Timothy Marshall, the bank's president. "But it's not prudent to do both loans at this point in time. We're in a more risk-averse mode." Mr. Marshall's reluctance sheds light on a problem looming over the economy. A year and a half after the financial crisis hit, the U.S. credit machine is still malfunctioning. During the boom, credit was too abundant. Now the pendulum has swung. With an eye toward limiting such swings, Sen. Christopher Dodd is expected to unveil a bill Monday that would be especially tough on big banks while preserving the Fed's regulatory role, but the bill's prospects remain uncertain.
For a recovery to take hold, hundreds of thousands of small businesses must find the confidence to expand and create jobs. But when they get to that point, the local banks they depend on—worried about borrowers' financial strength, scrutinized by regulators and slammed by souring real-estate loans—might not be willing or able to provide the credit they need. While big companies have been able to borrow in bond markets, smaller companies rely mainly on bank credit, which has been shrinking. In 2009, total lending by U.S. banks fell 7.4%, the steepest drop since 1942. In all, the credit pulled out of the economy by banks since the downfall of Lehman Brothers in September 2008 amounts to about $700 billion, more than double the amount so far distributed under President Barack Obama's $787 billion stimulus program.
"It's a dismal situation," says Diane Swonk, chief economist at Chicago-based financial-services firm Mesirow Financial. "Banks won't lend to businesses because they're afraid they'll go bad, but that can become a self-fulfilling prophecy." The dearth of credit for small businesses could have a big effect on prospects for restoring the 8.4 million jobs lost since the recession began. From 1992 through the beginning of the latest recession, companies with fewer than 100 employees accounted for about 45% of net job growth, according to Labor Department data.
Policy makers have been looking for ways to reopen the spigot. President Obama has proposed creating a $30 billion fund to support small-business lending. Last month, in an unusual show of solidarity, the Federal Reserve, the Federal Deposit Insurance Corp. and other state and federal regulators issued a joint statement urging banks to continue lending to credit-worthy small enterprises. Making sure small firms get access to credit "is crucial to avoiding a Japan-type scenario of persistent stagnation," says Mark Gertler, a New York University economist who has done seminal research with Fed Chairman Ben Bernanke, then a Princeton University professor, on how troubles with bank lending can aggravate economic downturns.
Getting banks to lend more won't be easy, given the rising tide of defaults on loans made to finance housing developments, office buildings, shopping malls and other commercial real estate. Deutsche Bank expects banks to suffer at least $250 billion in losses on such loans, with about half coming in the next few years. Together with an estimated $250 billion in further charge-offs on home mortgages, that's more than double banks' current reserves against losses on all types of loans. The stakes are particularly high for community banks, which tend to be much more active in commercial real estate than their larger counterparts. As of December 2009, such loans comprised about 42% of all loans held by the 7,344 banks with less than $1 billion in assets, compared to about 17% for the hundred or so banks with more than $10 billion in assets.
Some bankers say policy makers' desire to encourage lending isn't always reflected on the ground, where they say bank inspectors are getting tougher about lending standards. "For the first time in my 37 years in banking, we're having to say to our clients that we're not sure this will pass muster with the regulators," says Larry Barbour, president and chief executive of North State Bank in Raleigh, N.C. "That's not healthy." Washtenaw County, Mich., which includes Ann Arbor, Ypsilanti and Saline, offers a glimpse of how the cycle of economic malaise and shrinking credit is playing out across the country. The county includes the Willow Run plant, where Ford Motor Co. once produced the B-24 Liberator bombers that helped win World War II, the University of Michigan football stadium, and hospital complexes and high-tech start-ups in Ann Arbor. As of December, Washtenaw's unemployment rate stood at 9%, close to the national average.
Michigan Ladder's Mr. Harrison, 44 years old, remembers vividly the day in September 2008 when the recession hit home. The company, which manufactures wooden ladders and distributes imported aluminum and fiberglass models, had been doing well despite the financial crisis. Sales were up 6% over the previous year, and Mr. Harrison had expanded the company's staff to about 28, from 20 at the beginning of the year. But during the week of Sept. 15, the company's largest supplier of aluminum and fiberglass ladders suddenly refused to deliver ladders unless it was paid in advance. Within days, says Mr. Harrison, Michigan Ladder lost as much as $1 million of the supplier credit on which it relied to pay for raw materials and maintain its inventory of ladders. At the same time, its customers started failing to pay for ladders it had already delivered.
"Literally overnight, the whole world changed for us," says Mr. Harrison. "It was simply too much of a shock—too much of a change, too quickly." He laid off eight workers in December 2008 and another eight in 2009 as sales fell 40%. Mr. Harrison has since lined up new credit from suppliers, and he says sales are on track to rise 15% this year. He thinks the time has come to implement the expansion project he shelved when the crisis hit. The plan: Produce in Michigan the aluminum and fiberglass ladders he currently imports from places such as Mexico and China. He already has the customers, and he calculates that manufacturing in Michigan will actually boost his profit margins, in part because the savings on shipping will offset the higher cost of U.S. labor.
"We can do this," he says. "We can be a low-cost producer, and we will have a made-in-USA product, which we think will have some appeal to people." The Bank of Ann Arbor is Mr. Harrison's best bet to finance his project. Larger banks typically don't deal with companies the size of Michigan Ladder. Also, Bank of Ann Arbor, which has $543 million in assets, has weathered the crisis much better than most of its peers. It turned profits every year, expanded overall lending and declined the support of the government Troubled Asset Relief Program.
The bank has made loans to finance expansions for some of its stronger customers, such as Solohill Engineering, which makes products used in the manufacture of vaccines and more than doubled sales in 2009. Nonetheless, says its president, Mr. Marshall, fears about a weak recovery are prompting even healthy banks to be careful, a trend he recognizes could help make those fears a reality. "It's kind of a vicious cycle," he says. "Anytime you're in an economic environment like we are, bankers are going to be more conservative."
One of bankers' main concerns is the damage the recession has done to many companies' finances. Values of real estate and other things small business owners can put up as collateral for loans have fallen so far, so fast, that many businesses have little to offer. Also, a year or more of losses have eroded the value of owners' stakes in companies, leaving less of a cushion against bankruptcy. Mr. Marshall says such financial concerns are a big reason he's not ready to lend to Mr. Harrison, who says his company took heavy losses in 2008 before returning to profitability in 2009. Mr. Harrison says he's exploring ways to raise new money from investors, but so far to no avail. "It's not reasonable to expect that [the Bank of Ann Arbor] can make up for all the credit companies like ours have lost," he says.
Mr. Harrison's credit difficulties also are linked to the travails of other borrowers such as Mr. Haeussler, the 51-year-old president of Peters Building. In 2005, he and a partner began developing a 625-acre piece of land known as Saline Valley Farms, the site of a cooperative farm in the mid-1900s. The downturn hit Mr. Haeussler hard in 2007, when home builder Toll Brothers called with bad news: It wouldn't exercise its option to purchase 93 luxury-home lots, the entire first phase of the Saline Valley Farms project. When the $8.3 million loan he and a partner had taken out to grade the lots and build infrastructure came due in late 2008, they still owed $6.7 million and had 76 empty lots, the estimated value of which had fallen to about $1.4 million.
"It was perfectly wrong timing," says Mr. Haeussler. Losses on loans to developers such as Mr. Haeussler have taken a toll on community banks, eroding their capital and limiting their capacity to make new loans. Bank of Ann Arbor has moved more quickly than other banks to recognize losses, charging off nearly one-quarter of its construction and development loans in 2009. That compares to about 5% for all banks. In its remaining portfolio of such loans, about 6% are delinquent, compared to about 16% for all banks.
Many community banks are renegotiating troubled real-estate loans. In Mr. Haeussler's case, the Bank of Ann Arbor cut a deal: In return for a four-year extension, Mr. Haeussler and his partner more than quadrupled the amount of collateral backing the loan, putting up the entire Saline Valley Farms project and more. Even with the added collateral, the bank charged off $2.1 million of the loan, effectively recognizing that it may never get the money back.
The bank figures that giving Mr. Haeussler more time increases the odds he will pay off his loan. But such deals tie up cash on what essentially are bets that existing borrowers will make it through. That leaves banks, including Bank of Ann Arbor, with less appetite to make new loans to customers like Mr. Harrison, who doesn't have the resources Mr. Haeussler and his partner used to secure their loan. Mr. Haeussler, for his part, says he's trying not to think too much about all that's hanging in the balance, which could include his entire business. "It's a little unnerving at times," he says. "But you just have to put your head down and work through it."
Leading Countries Face a Debt 'Balancing Act'
Moody's sees ratings challenges for U.S., U.K., France, Germany
The four large triple-A-rated countries—the U.K., the U.S., France and Germany—face "an increasingly delicate balancing act" as they consider spending cuts to reduce government debt, Moody's Investors Service said in a review of these country's ability to retain their top credit-rating status. The credit-rating company repeated that there was no immediate risk of a downgrade of the big triple-A-rated countries, although the slight risk they could fail to get their finances under control, and thus be downgraded, has increased. Moody's concluded that "on balance, we believe that the ratings of all large triple-A governments remain well positioned—although their 'distance-to-downgrade' has in all cases substantially diminished."
All large triple-A governments "have the capacity to rise to the challenges they face," the rating agency said in its quarterly report on triple-A-rated sovereign issuers. A downgrade to any of these countries, as well as being viewed as a national humiliation, could significantly increase the government's interest bill. Moody's noted that while the global economy seems to be recovering, much of the rebound has bypassed the four countries, dashing their hopes that economic growth would help solve their debt problems and meaning that government spending would have to be cut. This has created "substantial execution risk" as countries try to make cuts without derailing the recovery and "damaging a government's main asset: its power to tax," the rating agency said.
Governments can't dodge the need for cuts by keeping stimulus packages in place and going for growth, Moody's warned, because this could test the confidence of financial markets, or of central banks, which might move to combat inflation expectations by raising interest rates. "At the current elevated levels of debt, rising interest rates would quickly compound an already complicated debt equation, with more abrupt rating consequences a possibility," Moody's said.
Still, even if a large triple-A-rated country reached the level at which interest payments reach 10% of revenue, Moody's said it wouldn't automatically lead to a downgrade. Instead, the ratings company said, it would look at the concept of "debt reversibility," or the degree to which governments are able and willing to get the debt level under control over a period of five to seven years. This, in turn, is linked to a country's political system and its ability to inflict deep spending cuts on itself.
Among the four largest triple-A-rated sovereigns, France has the lowest "debt reversibility margin", at 1%, Moody's said. This could mean that a rise in France's debt-affordability ratio above 11% would have rating implications, because a return to single digits in the foreseeable future would look unlikely unless the French government "demonstrated a reaction capacity well above that observed so far." Germany's margin is higher, at 2%. The U.K. and the U.S., where debt affordability is most stretched, enjoy margins of 3% and 4% respectively. However, Moody's said its figures for debt-reversibility margins aren't "hard triggers for rating decisions."
In its country-by-country assessments, Moody's said that for the U.S., a rise in the proportion of revenue that the government spends servicing its debt over the next 10 years, as outlined in the federal budget in February, would put the U.S. government's triple-A rating under pressure. However, it said federal debt affordability has "for the time being" not deteriorated despite the U.S.'s rising deficit, and isn't yet at a level that threatens the rating. Including state and local government debt, the affordability of general government debt would exceed 10% under Moody's baseline scenario in 2013. Under the agency's adverse scenario, it would exceed 14%, taking it beyond the possible buffer provided by Moody's 4% debt-reversibility margin.
"Both federal and general government affordability is growing more vulnerable to any shift in market confidence that would lead to higher interest rates than assumed in these projections," Moody's said. The 10-year outlook in the budget shows a continuous rise in the debt-affordability ratio, to around 18%, roughly the peak level when interest rates were high in the 1980s. "If such a trajectory were to materialize, there would at some point be downward pressure on the Aaa rating of the federal government," Moody's said. The U.S. has said it will set up a National Commission on Fiscal Responsibility and Reform, which will recommend ways to confront the federal deficit, but Moody's said that "the politics" of implementing any suggestions "remain uncertain."
For the U.K., it said, the top-notch credit rating depends primarily on investor confidence that "resolute action" will be taken to bring debts under control, rather than when exactly such steps will begin. Moody's also warned that if U.K. government bond yields move significantly higher, it "would not be consistent" with a triple-A rating over time. It said the suspension of the Bank of England's bond-buying plan poses an upside risk in this regard. Germany's debt-affordability ratio is projected to stay well below double digits for the next two to three years, Moody's said. The French government's triple-A rating faced no near-term danger because debt affordability should stay in the triple-A range "under most plausible scenarios," the report said.
The $2 Trillion Hole
Like a California wildfire, populist rage burns over bloated executive compensation and unrepentant avarice on Wall Street.
Deserving as these targets may or may not be, most Americans have ignored at their own peril a far bigger pocket of privilege -- the lush pensions that the 23 million active and retired state and local public employees, from cops and garbage collectors to city managers and teachers, have wangled from taxpayers.
Some 80% of these public employees are beneficiaries of defined-benefit plans under which monthly pension payments are guaranteed, no matter how stocks and other volatile assets backing the retirement plans perform. In contrast, most of the taxpayers footing the bill for these public-employee benefits (participants' contributions to these plans are typically modest) have been pushed by their employers into far less munificent defined-contribution plans and suffered the additional indignity of seeing their 401(k) accounts shrivel in the recent bear market in stocks.
And defined-contribution plans, unlike public pensions, have no protection against inflation. It's just too bad: Maybe some seniors will have to switch from filet mignon to dog food.
>Most public employees, if they hang around to retirement, can count on pensions equal to 75% to 90% of their pay in their highest-earning years. And many public employees earn even more in retirement than their best year's base compensation as a result of "spiking" their last year's income by working ferocious amounts of overtime and rolling in years of unused sick and vacation days into their final-year pay computation.
A survey by the watchdog group California Foundation for Fiscal Responsibility found that some 15,000 Golden State public employees are knocking down $100,000 or more, while some 200, mostly police and fire chiefs and school administrators, are members of the $200,000-a-year-and-up club.
THE PROSPECTS ARE BLEAK for many state and local governments as a result of all this. According to a survey last month by the Pew Center on the States, a nonpartisan research group, eight states -- Connecticut, Illinois, Kansas, Kentucky, Massachusetts, Oklahoma, Rhode Island and West Virginia -- lack funding for more than a third of their pension liabilities. Thirteen others are less than 80% funded.
Governments could fill that gap by raising property, sales and income taxes, but most are wrestling with huge revenue shortfalls in trying to balance their budgets.
The more likely outcome is dramatic cuts in essential services, such as police and fire protection, health spending, education and infrastructure improvements, in order to cover ballooning pension payments. State and municipalities, after all, must do something: Most have a legal obligation to pay out earned pension benefits. And some don't even have the courage to switch new teachers, bureaucrats and police to a defined-contribution system, to prevent the funding problem from worsening as time rolls on.
THUS, MORE DEBT DEFAULTS and bankruptcy filings probably lie ahead, unsettling the $2.7 trillion municipal-bond market. The possibility of taxpayer revolts and likely insolvencies has shaken some investors' confidence in general-obligation bonds -- those backed by the "full faith and credit" of the states or localities. Once the gold standard for munis, GOs are under a cloud in financially troubled areas.
The size of the legacy-pension hole is a matter of debate. The Pew report puts it at $452 billion. But the survey captured only about 85% of the universe and relied mostly on midyear 2008 numbers, missing much of the impact of the vicious bear market of 2008 and early 2009. That lopped about $1 trillion from public pension-fund asset values, driving down their total holdings to around $2.7 trillion.
Other observers think the eventual bill due on state pension funds will be multiples of the Pew number. Hedge-fund manager Orin Kramer, who is also chairman of the badly underfunded New Jersey retirement system, insists the gap is at least $2 trillion, if assets were recorded at market value and other pension-accounting practices common in Corporate America were adopted.
Finance professors Robert Novy-Marx at the University of Chicago and Joshua Rauh of Northwestern University asserted in a recent paper that the funding gap for state pension plans alone might exceed $3 trillion, in part because state funds are using an unrealistic long-term annual investment return of 8% to compute the present value of future payments to retirees, as is permitted in government standards for pension-fund accounting.
This establishes a "false equivalence" between pension liabilities and the likely investment outcomes of state investment portfolios, which are increasingly taking on more risk by beefing up their exposure to stocks, private-equity deals, hedge funds and real estate. Using a much lower expected return -- say, one at least partially based on the riskless rate of return on government securities -- would both properly and dramatically boost the present value of the pensions' liabilities while decreasing their likely ability to meet them. The academic pair, using modern portfolio theory, claim that state funds, as currently configured, have only a one-in-20 chance of meeting their obligations 15 years out.
MAKING THE STATE AND local pension problem all the more trying is that government entities can do little to wriggle out of their exposure, even if spending on essential services is threatened. The constitutions of nine states, including beleaguered California and Illinois, guarantee public-pension payments. And most other states have strong statutory or case-law protections for these obligations. "One shouldn't be surprised by this, since state legislators, state and local judges and the state attorneys general are beneficiaries of the self-same public pension funds that they've done so much to promote and protect," Orin Kramer notes wryly.
True, a dozen or so states, including New York, Nevada, Nebraska, Rhode Island and New Jersey, are attempting reforms such as raising retirement ages, cutting pension-benefit formulas, boosting employee contributions, curbing income "spiking" and partially switching employees to less costly defined-contribution plans. But these changes affect almost exclusively new employees and do little to solve the existing funding gap.
The municipal-bond market, for one, seems vulnerable to the growing public pension mess. Warren Buffett, in his 2007 Berkshire Hathaway annual report, inveighed against the "woefully inadequate" funding in many public pension funds to meet "huge" promised payments to retirees. True to his word, Buffett has sold precious little municipal-bond insurance in a Berkshire Hathaway unit he set up for that purpose in 2008.
Jim Spiotto, a muni-bond restructuring expert at the Chicago law firm Chapman & Cutler, argues the pension crisis is quickly reaching a tipping point after being ignored for years.
"I just can't believe that any bond issuer would be willing to suffer the stigma of defaulting on their general-obligation debt as a result of having to fund future pension obligations, but such a situation is no longer beyond the realm of possibility," he observes.
For proof, look no further than the San Francisco Bay city of Vallejo, which filed for Chapter 9 bankruptcy in 2008 as a result of insolvency.
The California municipality, which has 120,000 residents, is proposing a three-year moratorium on all interest and principal payments on the $53 million of municipal debt that is backed by its general fund. But it is keeping fully intact its $84 million in pension-fund obligations.
SOVEREIGN DEFAULT IS A hot topic these days. With Greece tottering and other European countries in fiscal distress, some have even voiced the possibility that a U.S. state -- also considered a sovereign entity -- could suffer a general-obligation debt default.
Says Todd Zywicki, a law professor at George Mason University: "In many ways, some of our states are like General Motors before its bankruptcy, suffering from falling revenue, borrowing money to cover operating expenses and operating under crushing legacy health and pension liabilities. It's entirely possible, given the gigantic size of the pension liabilities, that some states might do what was once the unthinkable at GM and default."
Such assessments might be alarmist. A rebound in the U.S. economy and a continued rally in stocks would do a world of good for ailing public pension funds. And only one state -- Arkansas in 1934 -- has defaulted on its GO bonds in the past century with their holders suffering losses. Arkansas, however, was a special case. In addition to the Great Depression, it was ailing from large local debts it had assumed as a result of catastrophic floods in the 1920s.
But what if the stock-market rally falters, the economy doesn't return to full health, jobs remain scarce and tax revenues remain depressed?
According to muni-bond expert Spiotto, most defaults at the municipal level have come as a result of shortfalls in the revenue generated by quasi-public projects, such as hospital additions, sports facilities, housing-development infrastructure, giant garbage incinerators and the like, rather than systemic financial failures of major localities like Vallejo. And even after New York City's debt default in 1975, municipal-debt holders were ultimately made whole.
NONETHELESS, SOME MAJOR BOND investors are altering their strategies in light of the impending pension crisis.
John Cummings, the executive vice president in charge of the $27 billion muni portfolio at giant fixed-income house Pimco, says it is underweighting the GOs of the "poster boys" of debt problems and pension under- funding -- California, Illinois, New Jersey and Rhode Island. Revenue bonds -- those backed by the money generated by a specific source -- have become more attractive to Pimco, particularly if they're backed by essential services like water authorities, sewer systems or school districts and have dedicated, stable revenue streams that can't be diverted to other uses. Revenue bonds funding new projects could be considerably more risky.
Says Cummings: "We want to stay as far away as possible from bonds that depend on the politicians and general funds of financially shaky states and smaller issuers unless the price is right. You ask California Treasurer Bill Lockyer, one of the greatest bond salesman ever, about the state's pension situation and all you get back is a thousand-yard stare and a quick change of subject. That's concerning."
A spokesman for Lockyer told Barron's that the treasurer "realizes that the pension-underfunding problem is serious, unsustainable and therefore needs to be fixed. He wants to ensure that any reform is fair to all stakeholders, including the state, public employees and taxpayers."
No one, of course, would dispute that public servants deserve adequate retirements, particularly the 25% to 30% that lack Social Security coverage. But the old saw that rich retirement packages are a necessary inducement to attract good employees to public payrolls because of below-average pay scales no longer is true.
According to the latest compensation survey by the Bureau of Labor Statistics, the average state and local employee outearns his counterpart in the private economy with an hourly wage of $26.11, versus $19.41. That's before benefits (pensions, health care, paid vacations and sick days and leaves) drive the disparity even higher, to $39.60 an hour for public employees and $27.42 for private workers.
Even if one looks at pay received by so-called management and professional employees in each realm, fat benefits in the public sector drive the total compensation received by state and local managers to almost dead-even with private-sector managers -- $48.15 versus $48.17.
THE CURRENT STATE AND local pension crisis has many fathers. State and local governments have been under-funding their pension systems for a decade or more, under the misapprehension that the stock-market boom of the 1990s would continue and bail out any shortfalls. The underfunding has continued with a vengeance over the past two years as budgets were slashed to eliminate deficits.
For example, last year New Jersey, under Gov. Jon Corzine -- a financially savvy former Goldman Sachs chief -- contributed only $105 million, instead of an actuarially determined $2.3 billion. In all, states and localities kicked in $72 billion in fiscal 2008, far short of adequate funding levels of $108 billion, according to the recent Pew study.
Such behavior is only encouraged by the fact that state and local governments are allowed as much as 30 years to close funding gaps. So it's easy for politicians to kick the can forward, avoiding the pain of boosting taxes and making hard spending decisions. The 30-year amortization periods have an evergreen nature, being renewed and invoked almost every year as the compounding of pension obligations works relentlessly against units of government.
Then, too, pension funds are being hit by baby-boomer retirements. A report from the National Association of State Retirement Administrators underlines this impact: It found that in 2008, for every state retiree collecting benefits, only 2.02 current workers were contributing to pension systems, compared with 2.45 in 2001.
Besides the politicians, the primary culprits are the public-employee unions, which have used their growing power to dramatically enhance pension benefits. They curry favor with sympathetic politicians, lavishing them with large donations and manning campaign phone banks. They also engage in full-court-press lobbying at all levels of state and local government.
One would think legislators or managers in state, county and local governments would protect the taxpayer by bargaining hard. But they clearly don't, because of inherent conflicts of interest.
Nearly all public employers, regardless of their position, benefit from the very same pension programs, either directly or indirectly. Legislators in the main receive the same pension benefits that they lavish on other public employees. And administrators, though subject to independently negotiated contracts, use enriched union pension plans as a valuable bargaining wedge. So there's little incentive to fight the unions with much vigor.
In fact, bad behavior abounds on both sides of the table when it comes to pensions. Plunder!, a recently published book by California journalist Steven Greenhut, details a number of ploys that both workers and management employ to goose their retirement checks. A favorite, he asserts, is income spiking. In the year before they retire, California police, firefighters and prison guards typically start notching hours and hours of overtime that has been reserved for them by less senior colleagues. Whatever they make in that final year is used in the formula that determines the monthly retirement check. Golden State, indeed.
OTHER ABUSES DETAILED in the book include widespread "double-dipping." Public employees can start collecting their full pensions while returning to their old job as consultants. Alternatively, they can take another public-sector job to earn credit toward yet another pension.
Stories are rife around the country of various pension hijinks by public employees. A Contra Costa Times article bemoaned the artistry of a retired local fire chief in San Ramon, Calif., who boosted his annual pension from $221,000 a year to $284,000 by getting credit in his final earnings for unused vacation and sick leave.
In Illinois, veteran police with more than 12 years of service receive annual longevity pay boosts of 4% to 5% in addition to other salary increases. In some local departments, these boosts are all awarded as a 20% bump-up in the first couple months of the year, rather than prorated evenly throughout the year. This, of course, helps police in those jurisdictions get a 20% jump in their presumed compensation -- and, therefore, their pensions -- if they time their retirement date properly.
VALLEJO, CALIF., HAD NO CHOICE but to file a Chapter 9 bankruptcy in 2008 after property-tax revenue collapsed in the housing bust and a major employer -- the U.S. government's Mare Island Ship- yard -- closed. With the tax base hammered, rich public-employee contracts granted in better times were devouring more than 90% of the city's budget.
Though Vallejo is still months away from getting a court decision on whether it can go ahead with its debt-adjustment plan, it has succeeded through contract renegotiations and major layoffs in cutting its employee costs by nearly a quarter.
But the fallout has been brutal. Employee health-care benefits have been decimated. Holders of the city's municipal bonds are unlikely to get all their money back. And violent crime rates have shot up dramatically as a result of reductions in its police force from 158 to 104 officers.
The only thing that will be left untouched? The very thing that tipped the California city into Chapter 9 -- its $84 billion in future pension obligations.
Lehman balance sheet massaging may not be unusual
On Wall Street, massaging the balance sheet is a time-honored practice. But did Lehman Brothers Holding Inc cross a line in the routine manipulation of its balance sheet, as described by an independent examiner? That is the central question to emerge from the examiner's report, released late on Thursday by the bankruptcy court in Manhattan, which details examples of Lehman concealing assets and liabilities through accounting techniques.
Thomas Baxter, general counsel of the Federal Reserve Bank of New York, one of the main banking regulators, told the examiner, Anton Valukas, that he was generally aware of firms using "balance-sheet window dressing," but had no specific information on Lehman. Banks have wrestled with this issue for years. The old Bankers Trust, for instance, struggled to fend off bank clients that wanted to use BT to help conceal assets, said Ray Soifer, a consultant who previously worked at BT and sat on a task force designed to reduce that business. "Reducing leverage is something that banks do. It's cosmetic," Soifer said.
In 2003, an internal review into accounting irregularities at Freddie Mac found the government-sponsored mortgage finance firm had periodically rented out its balance sheet to a Credit Suisse Group AG mortgage trader.
The review found that Freddie Mac entered into a series of deals with Credit Suisse that allowed the investment bank's trading desk to "park" some $8 billion in mortgage-backed securities on the mortgage firm's balance sheet. Over the years, one common trick has been to borrow money at the beginning of the quarter and invest it in short-term bonds that mature before the end of the quarter. When the bonds mature, the bank pays back its debt and it has fewer assets and liabilities.
The upshot is that the bank generates more profit off what appears to be fewer assets, giving it a better return on assets, a commonly watched measure of profitability. One former chief executive at a bank noted this method can goose earnings higher, but is terrible for the company long term because it does not build the overall franchise. For commercial banks, regulators caught onto this trick years ago, which is why banks typically report average assets during the quarter in addition to assets at the end of the quarter, both to the public and to regulators.
But major investment banks did not have that obligation and, even now, often do not report their average assets to investors. "Nobody knows if other banks are doing this kind of thing," said Brad Hintz, an analyst at Sanford Bernstein who was Lehman's Chief Financial Officer in the 1990s. But he said the question is sure to come up in conference calls for Morgan Stanley and Goldman Sachs Group Inc.
HOW IT WORKED
The mechanism that Lehman used for concealing assets and liabilities was much more complicated than borrowing at the beginning of the quarter and paying down debt at the end. It involved a series of short-term transactions similar to repurchase or repo deals, which entail selling assets and agreeing to buy them back in the future, according to the examiner's report. Lehman's deals were known as Repo 105 transactions. But instead of treating them as financings, Lehman classified these repo deals as "sales," which permitted the investment bank to keep the transactions off balance sheet.
Here is how it worked: Lehman essentially transferred assets to its London unit, which was the only jurisdiction where the bank could get lawyers at Linklaters to sign off on the deals. At the end of a quarter, Lehman would sell high quality assets to a counterparty -- the examiner's report mentions multiple European and Japanese banks -- for cash. The investment bank typically got cash equal to about 5 percent less than the face value of the asset. Lehman used the cash to pay down debt. At the start of the next quarter, Lehman would buy back the assets and borrow funds again. The net impact was the bank had lower assets and liabilities, making it appear to have less debt relative to its equity than it really did.
These transactions may have started out small in 2001, but by 2008 Lehman was using them to move big chunks of assets. The bank did about $50 billion of these transactions in the second quarter of 2008, which reduced its reported assets by about 7 percent, based on the company's financial statements for that quarter. That reduced its leverage ratios by nearly 2 points. The massaging allowed Lehman's leverage numbers to look much better than competitors. According to data compiled by Bernstein's Hintz, Lehman's net leverage ratio was 14.7 in the second quarter of 2008, compared with 20.8 for Goldman Sachs. Net leverage excludes repo assets and looks at assets compared with equity.
Lynn Turner, a former chief accountant for the Securities and Exchange Commission and now senior advisor to the consulting firm LECG, said the decision by Lehman executives to make greater use of Repo 105 is consistent with what companies do when they get themselves into trouble. "Companies never just fudge it a little bit," said Turner. "They start out just doing it a little bit and over time it grows and grows." While Turner said he was not aware of the Repo 105 transactions during this time at the SEC, he said it is fair "to wonder if anyone else is doing it." Turner added: "No one is going to stand up and say so."
Could Lehman be Ernst & Young's Enron?
Ever since the fraud at U.S. energy trader Enron Corp brought down accounting firm Arthur Andersen eight years ago, global auditing firms have worried that a major misstep could be fatal. Over the past few years, the firms have pushed for liability caps on litigation and settled dozens of cases, all amid concerns that each of the "Big Four" accounting firms faces potential litigation from undetected frauds at large public companies that could destroy them.
Ernst & Young became the latest auditor to come under fire this week after the court-appointed examiner in the Lehman Brothers Holdings Inc bankruptcy said the audit firm did not challenge accounting gimmicks that allowed Lehman to hide some $50 billion in assets in 2008, while claiming it had reduced its overall leverage levels. "As an auditor, you're always concerned when you're auditing a large company that ultimately fails," said Lynn Turner, a managing director in the forensic accounting practice at consulting firm LECG and former chief accountant of the Securities and Exchange Commission. "But a lot of those do occur where the auditors come out OK and the auditors aren't at risk -- obviously in this case the examiner thinks differently," Turner added.
At issue is a repurchase and sale program called Repo 105, which Lehman used without telling investors or regulators, and the examiner concluded was used for the sole purpose of manipulating Lehman's books.
In the examiner's report Lehman executives described the Repo 105 as everything from "window dressing" and an "accounting gimmick" to a "drug." According to the examiner's report, Ernst & Young's lead partner on the Lehman audit said the firm did not "approve" the Repo 105 accounting policies, but rather "became comfortable" with its use.
Lehman, which filed the largest U.S. bankruptcy case in history on September 15, 2008, is likely to use some of the examiner's claims to pursue lawsuits against those it believes are responsible for the investment bank's collapse. "This is like the horses getting out of the starting gate on the track -- the lawyers are going to sue the pants off anyone and everybody involved," said Anthony Sabino, a securities law professor at St. John's University's Tobin School of Business. Bryan Marsal, chief executive of Lehman Brothers Holdings Inc and co-founder of restructuring firm Alvarez & Marsal, said through a representative that Lehman "will carefully evaluate it in the coming weeks to assess how it might help us in our ongoing efforts to advance creditor interests."
Lehman's examiner, Anton Valukas, found the repo transactions to be partly responsible for Lehman's demise, and said Lehman may have "colorable claims" against Ernst & Young for failing to notice that the repos lacked a business purpose. Auditors are supposed to "look at the substance" of such transactions in addition to seeing whether they have actually complied with U.S. accounting rules, Turner said, noting that he has not seen anything that would prove to him that the Repo 105 transactions complied with U.S. Generally Accepted Accounting Principles.
Ernst & Young said in a statement: "Our last audit of the company was for the fiscal year ending November 30, 2007. Our opinion indicated that Lehman's financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view." "After an exhaustive investigation the examiner made no findings in his report that Lehman's assets or liabilities were improperly valued or accounted for incorrectly in Lehman's November 30, 2007, financial statements." According to the examiner's report, Ernst & Young had just started planning for its year-end audit of Lehman, when the firm collapsed into bankruptcy. "They are going to say, hey, we got hoodwinked like everybody else," Sabino said. "They've got defenses. For the directors and the officers, they're in a much tougher spot."
But most troubling for the auditors could be allegations in the examiner's report that Ernst & Young did not inform the audit committee on Lehman's board about a whistleblower who had expressed concerns about the repos to them. For Ernst & Young, the firm has previously faced similar allegations that it failed to notify a board of directors when it discovered potential problems in a tangle with U.S. securities regulators over its audits of health club operator Bally Total Fitness. In December, the Big Four firm agreed to pay the U.S. Securities and Exchange Commission an $8.5 million fine, one of the highest settlements ever paid by an accounting firm.
Fines are not the only cost the firm might face, however. "If nothing else, it's perception -- this is going to cost them a whole lot in legal fees, and it's damaging to their reputation," Sabino said.
Further Lehmans revelations blocked by Barclays
Further damaging revelations about the collapse of Lehman Brothers are being held up in the US courts by Barclays. A 2,200-page examiner’s report into the collapse of the 158-year old institution, published last week, uncovered in forensic detail evidence that Lehman used "balance sheet manipulation" to mislead investors and regulators. It is expected to fuel a series of lawsuits that former Lehman executives and their auditors are already facing in the US courts.
The scathing report was described as "one of the most extraordinary pieces of work product I have ever encountered", by Judge James Peck, who commissioned it as part of his handling of the Lehman bankruptcy. Judge Peck added that the report, by New York City attorney Anton Valukas, "reads like a bestseller". Now legal sources say there is more to come with the publication of the millions of pages of Lehman e-mails, internal company files and documentary evidence from third parties that formed the basis of the report.
A court hearing will take place soon, possibly as soon as April 1, in which the examiner’s team is expected to argue for the release of these "underlying documents". "All of the parties have agreed to allow those documents given to [the examiner] under confidentiality agreements to be made public, with two limited exceptions that we are working out," a person familiar with the matter said.
The objectors include Barclays, which is concerned that some of the information on Lehman extracted from its databanks by Mr Valukas’ team of 70 lawyers may also contain commercially sensitive proprietary data that the bank does not want released because it involves clients. As Mr Valukas wants to make his findings as open as possible by putting up web links to all of the available material, a way is being sought through the courts to put the material, minus the commercially sensitive data, online.
The hearing is another headache for Barclays, which is currently being sued by the Lehman estate, currently going through bankruptcy, for the return of a $5 billion "windfall" it alleged was made buying Lehman’s brokerage. Barclays has disputed this sum, saying it was owed money on the deal. Mr Valukas’ report concluded that Barclays may have received "a limited amount of assets" improperly, including office equipment, during the transaction.
The other party objecting to publication of the underlying documents is the US Office of Thrift Supervision (OTS), a federal bank regulator established in 1989 in response to another financial crisis – the savings and loans disaster, is also seeking redactions, arguing that the information was handed over initially on the understanding that it remain confidential. Mr Valukas’ report exposes concerns expressed by the OTS concerning Lehman’s liquidity. After Lehman acquired and financed the $23.6 billion buyout of Archstone-Smith Real Estate Investment Trust in May 2007, along with the property company Tishman Speyer, the OTS noted that Lehman exceeded its own risk appetite limits. It criticised Lehman for being "materially over-exposed to commercial property and for entering into the Archstone deal without sound risk management practices
14 Fun Facts About The U.S. Government's Massive Debt Problem
The U.S. government is currently creating one of the most colossal monuments in the history of the world. It is the U.S. national debt, and it threatens to literally destroy the American way of life. For decades now, this generation has been recklessly spending the money of future generations and has been convinced that they have been getting away with it. Americans have been enjoying an obscenely high standard of living, but the party is almost over and the day of reckoning is fast approaching.
It has been a great party, but it was fueled by the biggest mountain of debt in the history of the world. As many of us know, it can be extremely fun running up a huge credit card bill, but it can be even more painful to pay it off. Now our national "credit card bills" are starting to arrive and nobody really seems to know what to do. The U.S. national debt will forever be a lasting reminder of the greed and recklessness of this generation. The truth is that the United States is NOT the "richest and most powerful nation" in the world. Rather, we are a spoiled, bloated, greedy nation that has run up a debt so big that words simply do not do it justice.
In fact, the U.S. national debt is so bizarre that it is hard to know whether to laugh about it or cry about it. For today at least, we will have some fun with it. The following are 14 fun facts about the U.S. government's massive debt problem....
#1) As of December 1st, 2009, the official debt of the United States government was approximately 12.1 trillion dollars.
#2) To pay this 12.1 trillion dollar debt would require approximately $40,000 from every single person living in the United States.
#3) Now the U.S. Congress has approved an increase in the U.S. government debt cap to 14.3 trillion dollars. to pay this increase off would require approximately $6,000 more from every man, woman and child in the United States.
#4) The U.S. government's debt ceiling has been raised six times since the beginning of 2006.
#5) So how hard is it to spend a trillion dollars? If you spent one dollar every second, you would have spent a million dollars in twelve days. At that same rate, it would take you 32 years to spend a billion dollars. But it would take you more than 31,000 years to spend a trillion dollars.
#6) When Ronald Reagan took office, the U.S. national debt was only about 1 trillion dollars.
#7) The U.S. national debt has more than doubled since the year 2000.
#8) Barack Obama’s most recently proposed budget anticipates $5.08 trillion in deficits over the next 5 years.
#9) The U.S. national debt on January 1st, 1791 was just $75 million dollars. Today, the U.S. national debt rises by that amount about once an hour.
#10) The U.S. national debt rises at an average of approximately $3.8 billion per day.
#11) In 2010, the U.S. government is projected to issue almost as much new debt as the rest of the governments of the world combined.
#12) The U.S. government has such a voracious appetite for debt that the rest of the world simply doesn't have enough money to lend us. So now the Federal Reserve is buying most U.S. debt, and the only reason they can do that is because they basically create the money to lend us out of thin air.
#13) A trillion $10 bills, if they were taped end to end, would wrap around the globe more than 380 times. That amount of money would still not be enough to pay off the U.S. national debt.
#14) As if all of the above was not bad enough, according to the 2008 Financial Report of the United States Government, which is an official United States government report, the total liabilities of the United States government, including future social security and medicare payments that the U.S. government is already committed to pay out, now exceed 65 TRILLION dollars.
Is China's Politburo spoiling for a showdown with America?
by Ambrose Evans-Pritchard
The long-simmering clash between the world's two great powers is coming to a head, with dangerous implications for the international system. China has succumbed to hubris. It has mistaken the soft diplomacy of Barack Obama for weakness, mistaken the US credit crisis for decline, and mistaken its own mercantilist bubble for ascendancy. There are echoes of Anglo-German spats before the First World War, when Wilhelmine Berlin so badly misjudged the strategic balance of power and over-played its hand. Within a month the US Treasury must rule whether China is a "currency manipulator", triggering sanctions under US law. This has been finessed before, but we are in a new world now with America's U6 unemployment at 16.8pc.
"It's going to be really hard for them yet again to fudge on the obvious fact that China is manipulating. Without a credible threat, we're not going to get anywhere," said Paul Krugman, this year's Nobel economist.
China's premier Wen Jiabao is defiant. "I don’t think the yuan is undervalued. We oppose countries pointing fingers at each other and even forcing a country to appreciate its currency," he said yesterday. Once again he demanded that the US takes "concrete steps to reassure investors" over the safety of US assets. "Some say China has got more arrogant and tough. Some put forward the theory of China's so-called 'triumphalism'. My conscience is untainted despite slanders from outside," he said.
Days earlier the State Council accused America of serial villainy. "In the US, civil and political rights of citizens are severely restricted and violated by the government. Workers' rights are seriously violated," it said.
"The US, with its strong military power, has pursued hegemony in the world, trampling upon the sovereignty of other countries and trespassing their human rights," it said. "At a time when the world is suffering a serious human rights disaster caused by the US subprime crisis-induced global financial crisis, the US government revels in accusing other countries." And so forth.
Is the Politiburo smoking weed?
I let others discuss the rights and wrongs of this, itself a response to the US report card on China. Clearly, Beijing is in denial about is own part in the global imbalances behind the credit crisis, specifically by running structural trade surpluses, and driving down long rates through dollar and euro bond purchases. No doubt the West has made a hash of things, but the Chinese view of events is twisted to the point of delusional.
What interests me is Beijing's willingness to up the ante. It has vowed sanctions against any US firm that takes part in a $6.4bn weapons contract for Taiwan, a threat to ban Boeing from China and a new level of escalation in the Taiwan dispute.
In Copenhagen, Wen Jiabao sent an underling to negotiate with Mr Obama in what was intended to be - and taken to be - a humiliation. The US President put his foot down, saying: "I don't want to mess around with this anymore." That sums up White House feelings towards China today. We have talked ourselves into believing that China is already a hyper-power. It may become one: it is not one yet. China is ringed by states - Japan, Korea, Vietnam, India - that are American allies when push comes to shove. It faces a prickly Russia on its 4,000km border, where Chinese migrants are itching for Lebensraum across the Amur. Emerging Asia, Brazil, Egypt and Europe are all irked by China's yuan-rigged export dumping.
Michael Pettis from Beijing University argues that China's reserves of $2.4 trillion - arguably $3 trillion - are a sign of weakness, not strength. Only twice before in modern history has a country amassed such a stash equal to 5pc-6pc of global GDP: the US in the 1920s, and Japan in the 1980s. Each time preceeded depression. The reserves cannot be used internally to support China's economy. They are dead weight, beyond any level needed for macro-credibility. Indeed, they are the ultimate indictment of China's dysfunctional strategy, which is to buy $30bn to $40bn of foreign bonds every month to hold down the yuan, refusing to let the economy adjust to trade realities. The result is over-investment in plant, flooding the world with goods at wafer-thin export margins. China's over-capacity in steel is now greater than Europe's output.
This is catching up with China, in any case. Professor Victor Shuh from Northerwestern University warns that the 8,000 financing vehicles used by China's local governments to stretch credit limits have built up debts and commitments of $3.5 trillion, mostly linked to infrastructure. He says the banks may require a bail-out nearing half a trillion dollars. As America's creditor - owner of some $1.4 trillion of US Treasuries, agency bonds, and US instruments - China can exert leverage. But this is not what it seems. If the Politburo deploys its illusiory power, Washington can pull the plug on China's export economy instantly by shutting markets. Who holds whom to ransom?
Any attempt to retaliate by triggering a US bond crisis would rebound against China, and could be stopped - in extremis - by capital controls. Roosevelt changed the rules in 1933. Such things happen. The China-US relationship is no doubt symbiotic, but a clash would not be "mutual assured destruction", as often claimed. Washington would win. Contrary to myth, the slide to protectionism after the 1930 Smoot-Hawley Tariff Act did not cause the Depression. Trade contracted more slowly in the 1930s than this time. The Smoot-Hawley lesson is that tariffs have asymmetrical effects. They devastate surplus countries: then America. Deficit Britain did well by retreating into Imperial Preference.
Barack Obama has never exalted free trade. This orthodoxy is, in any case, under threat in the West. His top economic adviser Larry Summers let drop in Davos that free-trade arguments no longer hold when dealing with "mercantilist" powers. Adam Smith recognized this too, despite efforts by free-trade ultras to appropriate him for their cause. China's trasformation has been remarkable since Deng Xiaoping unleashed capitalism, but as ex-diplomat George Walden writes in China: a Wolf in the World? you cannot feel at ease with a regime that still covers up Mao's murderous nihilism. He reminds us too that China has never forgiven the humilations inflicted by the West when the two civilizations collided in the 19th Century, and intends to exact revenge. Handle with care.
China's Wen Jiabao rebuffs U.S. on letting yuan appreciate against dollar
Chinese Premier Wen Jiabao on Sunday lectured the United States, criticizing its call for China to let its currency rise against the dollar to boost U.S. exports, advising it to work harder to improve its financial system and directing it to change its foreign policy to improve relations with China. Wen's comments -- during a news conference at the end of China's annual session of its nonelected legislature -- seemed to indicate that China would generally pursue a relatively tough line in its relations with the United States this year. The comments underscored China's increasing self-confidence on the international scene following its success at coping with the global financial crisis.
But Wen also continued to express caution about the course of domestic events, expressing concern about "the unsteady, uncoordinated and unstable development of the Chinese economy." China grew at 8.7 percent last year, the fastest of any major economy in the world, but it did so on the back of a massive stimulus package. Wen said China's economy faces many challenges including the possibility of a "double dip" recession if world growth doesn't pick up and, on the other hand, runaway inflation if it does.
Wen's statements on the currency issue appeared to close off the possibility that China would allow its currency, the yuan, to appreciate against the dollar anytime soon. On Thursday, President Obama, in rolling out a plan to increase American exports, called on China to adopt "a more market-oriented exchange rate [that] would make an essential contribution to that global rebalancing effort." Wen countered that he didn't think the yuan was undervalued and that the U.S. method -- seeking to enlarge exports through tweaking currency exchange rates -- was protectionist.
"I understand that some countries want to increase their exports, but I don't understand the practice of depreciating their currency and forcing others to appreciate theirs in order to accomplish this," Wen said. "I think this is a type of trade protectionism." China has pegged the yuan to the dollar since mid-2008 after it had allowed it to rise 21 percent during the previous three years. Theoretically, letting the yuan, or renminbi, appreciate again would make U.S. exports cheaper and thus more popular in China; it also might increase the price of Chinese goods, thereby lowering America's $225 billion trade deficit with Beijing.
U.S. officials have said they hope China will increase the value of the yuan before April 15, when the Treasury Department is scheduled to release a report on international currency practices. If that report determines that China is a "currency manipulator," meaning that it is keeping the value of the yuan artificially low, it could give added impetus in Congress to legislation that would slap tariffs on Chinese imports into the United States.
Wen also directed the United States to "take concrete steps" to improve its financial outlook and protect China's investments in U.S. Treasury bonds. China holds hundreds of billions of dollars in American debt -- so much, in fact, that the nation is often referred to as "America's banker." Wen reiterated comments he made at the National People's Congress conference last year that he was worried about China's investments.
Wen held out the hope of better ties with the United States, quoting a Chinese adage about scaling a mountain, but he continued the recent spate of criticism from Chinese officials, scolding the Obama administration for meeting the exiled Tibetan spiritual leader, the Dalai Lama, and selling a $6.4 billion package of weapons to China's nemesis, Taiwan.
China Altered Budget Accounting to Reduce Deficit Figure
China's finance ministry changed the accounting for some government spending this year in a way that allowed it to report a planned budget deficit below the symbolic level of 3% of gross domestic product, an examination of budget documents shows. In the budget report it submitted to the legislature earlier this month, China's Ministry of Finance estimated the total budget deficit for 2010 at 2.8% of GDP, "basically the same as last year." A strict cash accounting of government expenditures, however, would push the 2010 deficit up to 3.5% of forecast GDP, and reduce the 2009 deficit to 2.2% of GDP, according to calculations by The Wall Street Journal that were verified by three economists.
The accounting move simply shifts spending from one year to another, and so doesn't mean that the overall trend of China's government finances is worse than reported. Still, it raises questions about transparency, and highlights the Chinese government's desire to demonstrate strong public finances at a time when global markets are increasingly jittery about official deficits and debts. China's finance ministry has pledged to keep annual budget deficits below 3% of GDP – the same threshold that countries in the euro zone are supposed to observe.
Greece and other European countries have over the years used a number of accounting maneuvers to meet that obligation. In the run-up to the creation of the euro, France, Spain and Portugal made one-off changes to their budgets that allowed them to keep deficits below the 3% level for 1997. Subsequent revisions showed that the actual deficits for that year were above 3% of GDP for all three countries. It's not clear why China's finance ministry is so attached to the 3% target. China has no obligation to keep its deficits below that level, and many foreign economists have urged the government to run bigger deficits. China also does not face pressure from global financial markets to run tight government finances, as its enormous pool of domestic savings means it has little need to borrow from abroad. But China's government has in the past frequently faced questions from investors and its own public over whether official data accurately represent the state of the world's fastest-growing major economy.
In a 2008 survey by the International Budget Partnership, a nonprofit that promotes transparency in government finances, China scored 14 out of 100 points, the same as Burkina Faso. India scored 60, and the U.S. scored 82. China provides "scant information" about its public finances, which "makes it very difficult for citizens to hold the government accountable for its management of the public's money," the group said. The difference in the deficit accounting hinges on the treatment of 260.82 billion yuan, about $38 billion, in local government spending that was "carried over" from 2009. According to ministry's budget report, this money was allocated for projects in 2009 but wasn't actually spent. Though the money will be spent in 2010, it is still being counted as part of the 2009 budget.
In a written response to questions from The Wall Street Journal, China's Ministry of Finance confirmed that the "carried over" money is not included in its budget for spending in 2010. The ministry didn't answer more detailed questions about its accounting practices. It's not uncommon to account for spending in the time period when the commitment to pay the money is made: that is the practice under the accrual accounting used by many businesses. But most governments, including China's, have historically practiced cash accounting, which counts revenue and spending only when the money actually changes hands.
Under those principles, to count all of the cash the government will actually spend in 2010 requires adding the "carried over" funds to the 8.453 trillion yuan in formal budgeted spending. That would increase the budgeted 1.05 trillion yuan deficit for 2010 by 260.82 billion yuan, pushing it to 3.5% of expected GDP from 2.8%. In the end, China's actual budget deficit for 2010 could well turn out to be lower than either estimate, since they are both based on the finance's ministry forecast of 8% in revenue growth, which is widely seen as very conservative. The ministry also budgeted for 8% revenue growth last year, and actually achieved an 11.7% gain. So there may be little lasting impact from this year's accounting change.
Japan’s mythical debt crisis
How did the people who sighted the first black swan respond to the shock? After the collapse of the assumption that all swans were white, did they then conclude that swans could be any colour – red, green, or blue? That’s the kind of mistake that investors may be making now. Anyone who lived through the trauma of the global credit crisis will be psychologically primed for financial armageddon for years to come. Hence the appeal of huge "end times’" macro stories like the demise of the dollar, the break-up of the euro, and – most recently – the implosion of Japanese public finances.
The rationale for a Japanese debt crisis is clear. This year, for the first time ever, the Japanese budget will be more reliant on bond issuance than tax revenues. The ratio of Japan’s gross government debt to GDP has breached two hundred per cent. A Godzilla-sized rollover of Y210,000bn – equivalent to the entire public debt of Italy – will take place over the next twelve months. Challenging arithmetic, to say the least. The ratings agencies have already sounded the alarm, with S&P delivering a downgrade of Japanese debt in January. Celebrated investors and academics are forecasting meltdown, and one excitable financial journalist has described Japan as "our Weimar in waiting."
The only people who seem relaxed about Japanese public finances are the supposed vigilantes of the bond market. So far this year, while sovereign debt fears have spooked the European markets, JGB yields have been comfortably quiescent in the 1.2-1.4 per cent range. Only rarely and briefly in the past decade have they drifted above 2 per cent. Far from the next Lehman or the next Greece, the market is rating the Japanese government as the best credit on the planet. Indeed if Sidney Homer’s classic "History of Interest Rates" is any guide, Japanese government debt commands the lowest interest rate since Babylonian times.
There are only two possible explanations for this extraordinary divergence of views, both of them disturbing. Either the Japanese bond market is simply wrong, or our understanding of debt crises is flawed. We know only too well that markets can be wrong, but developed country government bond markets are supposed to be sober affairs, and ten years is a long time for a mispricing to persist. In fact, ever since the bursting of Japan’s 1980s bubble, there has been an inverse relationship between the debt to GDP ratio and bond yields – the more bonds the Japanese government sells, the easier the terms it gets.
The buyers of these bonds – deleveraging corporates, de-risking financial institutions, individuals turning their backs on equities and real estate – are hardly speculators. They have sound reasons for the choices they made. Not least is the fact that deflation – which is understated by Japan’s outmoded CPI calculations - generates an invisible tax-free gain to holders of cash and bonds. What this suggests is that debt dynamics are more mysterious than we thought. There is no magic debt-to-GDP ratio that leads inexorably to a crisis. The eurozone’s sinners got into trouble with far lower ratios - sub-50 per cent in Spain’s case – than Japan. What matters is the financeability of any given level of debt, which in turn depends on the availability of savings and the preferences of the savers.
Over the past twenty years, Japan’s private sector has not just been financing the home country’s bulging public deficit but a considerable proportion of the US’s public deficit too. The fact that Japan’s savings surplus is now concentrated in the corporate sector rather than the household sector doesn’t matter. With capacity utilisation so low, Japanese companies will be restraining capital investment for years – which means their cashflows will pass to other sectors of the economy via dividends and financial asset purchases.
So does that indicate everything in Japan is hunky dory? Far from it. Japan’s cellar-dwelling bond yields are a product of the deflationary disease that has been gnawing away at the economy’s vital organs. While deflation, persists the debt to GDP ratio is destined to go ever higher. Bizarrely, Japanese policy-makers have been more concerned with minimising the current interest rate on public debt than reflating the economy and generating higher tax revenues and lower social costs over the long haul. At some point they will have to reverse strategy, and when that happens bond yields will rise. Far from portending imminent doom, that would signify that Japan’s journey back to economic health had begun. And that really would be a green swan event.
Euro-Zone Employment Fell in 2009
The number of people in work across Europe dropped in 2009 for the first time in the 14-year history of the statistic, and could fall again this year if the fragile economic recovery fails to gain strength.
Eurostat reported Monday that the number of people in work in the 16-country euro zone declined 2.7 million in 2009 from a year earlier and was also down by 4 million in the wider 27-country European Union. Those falls follow full-year gains of 1.7 million and 2.6 million respectively in 2008.
"We believe that growth in most countries is unlikely to be strong enough to generate net jobs for some time to come and businesses will consequently be keen to keep their work forces as tight as possible," said Howard Archer, chief European and U.K. economist for IHS Global Insight. "Ongoing soft labor markets in 2010 are likely to hold down wage growth and limit the upside for consumer spending."
The euro-zone economy emerged from recession in the third quarter of last year although the pace of growth slowed in the fourth quarter, when gross domestic product grew just 0.1% from the third quarter following a 0.4% expansion between July and September. That slower pace of economic growth has been reflected in various data recently, including still-subdued consumption, relapses in rising business confidence and weaker or unchanged employment expectations.
The most up-to-date employment surveys suggest that while the pace of job cuts has slowed, companies' appetite to take on new staff remains limited as many countries begin to face the prospect of massive government support packages being slowly withdrawn as the economic growth expands only tentatively. Manpower's latest global employment outlook survey reported that the larger European countries, specifically Germany, showed that companies' intention to hire in the second quarter of this year is actually lower than it had been for the first three months of 2010. Plans to add staff in Italy and Spain were also weak, according to the survey.
This hesitation in spending by companies adds to the concerns already shouldered by consumers, many of whom are continuing to engage in thriftier behavior and are spending less than in more buoyant times ahead of widely expected government spending cuts and higher taxes. Euro-zone retail sales fell 0.3% on the month in January while consumer spending as a whole stagnated in the fourth quarter of last year. While this downbeat level of activity doesn't bode well for GDP growth, it does suggests inflationary pressures will remain subdued for some time, allowing the European Central Bank plenty of room to maintain its ultra-loose monetary policy.
ECB President Jean-Claude Trichet said at the latest monthly policy meeting that the economic recovery is expected to continue at a moderate pace and inflation should stay in check. He did, however, urge governments to begin planing exit strategies from stimulus programs. "Sectoral support schemes implemented to cope with the immediate effects of the crisis should now be phased out," he said.
Greece Plays Down Bailout Expectations
Greek officials are playing down expectations ahead of a critical meeting of European finance ministers this week that could decide the fate of a multibillion-euro aid package and will be key to the country's plans to move ahead with a new bond issue. That meeting, the first by European Union finance ministers since Greece announced a new €4.8 billion ($6.6 billion) austerity package two weeks ago, comes even as unions continue various strike actions to protest the new measures.
However, details of an EU aid package remain unclear. The plan is expected to provide a mixture of loans or loan guarantees for Greece's cash-strapped government, which the Greek government hopes will reduce the interest premium Greece pays over other EU borrowers such as Germany. "They want to help, but we think they still don't know how to do it, or at least they are not telling us," a Greek official said. "We are not looking for money, but for some support so that the spreads on our bonds become more logical."
Under pressure from the EU and financial markets, Greece's socialist government earlier this month announced a series of tax hikes and spending cuts aimed at reducing the budget deficit to 8.7% of gross domestic product this year, from an estimated 12.7% of GDP last year. Among other things, the package raises Greece's top value-added tax rate to 21% from 19%, freezes public-sector pensions, cuts civil-service entitlements and bonus pay and raises taxes on fuel, alcohol and cigarettes.
"We did what the EU expected from us and more. It's a tough austerity program and it's crazy to pay in interest rates what we save as the result of the [austerity] measures," the official added. As it is, the Greek public has given its grudging consent to the austerity measures--but opinion polls show there is little tolerance for more cutbacks. According to the Sunday edition of the Ethnos newspaper, 60.2% of Greeks think the austerity measures were necessary, and only 35% say the government could have opted for less harsh policies. But a second poll in the Sunday Eleftherotipia newspaper showed a large portion of Greeks are ready to take to the streets if the government proceeds with further cutbacks.
According to the second poll, 62% of respondents said they were ready to participate in labor protests if the government moves to increase retirement ages, further cuts salaries or pensions or eliminates extra-month bonus salaries. The polls follow a mass demonstration and general strike this past Thursday organized by Greece's two major unions--private-sector GSEE and public-sector ADEDY--which drew tens of thousands of protesters opposing the government's austerity package.
Members of Greece's militant power workers' union, Genop, staged a series of demonstrations around the country early Monday as they prepare for a two-day strike to protest the latest austerity measures. The 48-hour strike is set to begin at midnight local time and could lead to rolling blackouts around the country if Genop strikers leave the power plants short-staffed--a tactic the union has followed in the past. "We will decide this afternoon on how to proceed," said Nikos Hatzaras, a member of Genop's board of directors. "Of course, if all the workers at a power plant decide to walk out, then obviously, to safeguard the stability of the power system, some of the plants will close down. Greek nurses are also due to hold a 24-hour strike Tuesday, while on Thursday owners of gas stations have declared their own one-day strike.
Almost as important as the aid package will be the EU finance ministers' assessment of Greece's austerity program so far. A vote of confidence by the Council of Finance Ministers, or Ecofin, could help lead to a narrowing in the bond spreads between Greek government bonds and their benchmark German counterparts. This is widely seen as the signal the Greek government is waiting for before launching its next issue, possibly a medium-term bond of maturing in either three or seven years, with market analysts saying the latter is more likely. Greece must pay some €22 billion in redemptions in April and May and government officials say they would like to raise €10 billion this month, but acknowledge that could be difficult.
In midday trading Monday, the spread between 10-year Greek government bonds and German bunds narrowed slightly to 3.02 percentage points from Friday's close of 3.08 percentage points. Credit default swaps, which are used to insure bond holders against a default by Greece, were also largely stable. In early trading, the five-year sovereign CDS was trading at 293 basis points, after ending around 290 basis points on Friday. "Sovereign risk will remain the main theme in the European government bond market," said UniCredit strategist Luca Cazzulani. "With increasing expectations of a new Greek bond, and with the EU Commission expected to express a new assessment on Greece, volatility on [Greek government bonds] is expected to remain high also this week."
France Tells Germany It's Hurting Other Euro Countries
Germany’s trade surpluses built on holding down labour costs may be unsustainable for the other countries in the eurozone, France’s finance minister said in an unusually blunt warning to Berlin. Christine Lagarde said Berlin should consider boosting domestic demand to help deficit countries regain competitiveness and sort out their public finances. Her comments break a long-standing taboo between the French and German governments about macroeconomic imbalances inside the 16-country bloc which have been dramatically exposed by the Greek debt crisis.
"[Could] those with surpluses do a little something? It takes two to tango," she said in an interview with the Financial Times. "It cannot just be about enforcing deficit principles." "Clearly Germany has done an awfully good job in the last 10 years or so, improving competitiveness, putting very high pressure on its labour costs. When you look at unit labour costs to Germany, they have done a tremendous job in that respect. I’m not sure it is a sustainable model for the long term and for the whole of the group. Clearly we need better convergence."
After Wolfgang Schäuble, her German counterpart, last week proposed a European Monetary Fund associated with much stiffer penalties for breaking the EU’s fiscal rules, Ms Lagarde outlined her own thinking about closer economic policy co-ordination, laying bare the different visions of "economic government" held by Paris and Berlin. While not ruling out an EMF, she said it was not a priority for the eurozone. The bloc should first focus on ensuring that debt-laden Greece followed through on promised austerity measures and then show "a bit of creativity and innovation" to find scope within the existing EU treaty for beefing up budgetary surveillance and discipline.
Rather than amending a treaty to set up an EMF – "an adventure that could take us another three, four, five years" – the eurozone should adopt its own "soft laws" to strengthen discipline. Ms Lagarde said much tougher sanctions as proposed by Mr Schäuble were "worth exploring". But she preferred faster surveillance procedures and less painful but more realistic penalties, pointing out that the existing threat of a fine under the EU’s fiscal rules "is so far away and unlikely that it is not really a deterrent".
Ms Lagarde made clear the biggest difference between Germany and France – and other eurozone members - is over whether Berlin should boost internal demand to give a lift to its partners’ export industries. It was a "very sensitive issue", she acknowledged. "I talk to Wolfgang [Schäuble] on an almost daily basis at the moment. The issue of imbalances is not one we address readily." The rest of the eurozone could not expect too much of Germany, Ms Lagarde said. France and other governments had to make efforts to increase the competitiveness of their economies and reform their public sectors to reduce deficits. She paid tribute to Ireland which was "driving hard".
"You can’t ask one player, as big as it is, to pull the whole group. But clearly there needs to be a sense of common destiny that we have together with our partners." Ms Lagarde defended a proposed EU crackdown on credit default swaps on sovereign debt, which some believe has been used to manipulate the price of Greek debt. She said she had "no evidence" of price manipulation using sovereign CDS but added that the "rapidity of movements is intriguing". There needed to be a closer watch on a "narrow and shallow market with very few players", she added.
A complete ban on "naked selling" – trading the CDS without holding the underlying asset – would be an "oversimplication", she said. She said Greece’s debt problems underlined the need to step up efforts to overhaul the market in CDS more generally. The standardisation of contracts and the shift from over-the-counter to trades on organised exchanges – as agreed by the G20 group of leading economies – should be completed by the end of next year rather than by the end of 2012.
Municipal Deflation: Consequences of the Greatest Speculation
by Frederick Sheehan
"The financial difficulties of local governments in consequence both of the inflation and deflation of real estate values demonstrates strikingly the unwisdom of a revenue s ystem concentrated so heavily upon real estate…." – Herbert D. Simpson, Meeting of the American Economic Association, 1933 On March 10, 2010, the Kansas City Missouri School Board voted to close nearly half its schools (28 of 58). On the same day, Illinois Governor Pat Quinn warned that if the state income tax is not raised by 1%, education will face "draconian cuts."
To employ the most hackneyed metaphor of the recent financial meltdown, we are only in the first inning of municipal deflation in the United States. This has not gained much attention in the recovery vs. recession debate. Yet, states and municipalities spend around twice as much money as the federal government. (Since only the federal government can print money, this comparison may have changed in the last year.) The gap between tax receipts and spending is forcing big changes in Missouri and Illinois, though it is probable these cuts are miniscule in comparison to what is ahead.
A recovery is expected in tax receipts by those who think the economy is rebounding, but in fact the broad swath of municipalities will suffer deeper reductions in tax receipts for a long time to come. (Municipalities – cities and towns – receive most of their revenue from real estate taxes. State revenues are skewed towards income, corporate, and sales taxes.) The Great Depression taught this lesson but it was tossed in some ash heap of history. Revered economists are particularly immune to events that contradict their theories. In the 1938 Alfred Hitchcock movie, The Lady Vanishes, the mistaken psychiatrist is told: "You must think of a fresh theory." Doctor Hartz responds: "It is not necessary. My theory was perfectly good. The facts were misleading."
Doctor Hartz had a sound reason not to change his theory since reconsideration may have precluded his intent to murder his victim. In a similar vein, intended or not, Federal Reserve Governor Frederic Mishkin espoused a murderous theory that has claimed many victims: "To begin with, the bursting of asset price bubbles often does not lead to financial instability….There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability…. In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble." This prediction was made in January 2007 before the Forecaster’s Club of New York. (Novelists shy from such parody.)
Current theories and books written about the Depression do not dwell on the 1920s real estate boom. Real estate lending in the 1920s might rival the recent debacle, in form if not degree. There was a flight to the suburbs. The building balloon included houses, roads, sewers, schools, skyscrapers, and highways that crossed the country for the first time. When Treasury "Secretary Mellon endeavored to cut back federal spending, state and local governments stepped up spending at a rate that more than offset the Mellon program…."
This was speculative building on a grand scale, as Professor Herbert D. Simpson of Northwestern University informed the Forty-Fifth Annual Meeting of the American Economic Association in 1933: "Throughout this period there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This is the real estate ’speculation’ carried on by municipal governments, in the sense of basing approximately 80 per cent of their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance on the rate of profits and appreciation that had characterized the period from 1922-29."
In The Crash and Its Aftermath, A History of Securities Markets in the United States, 1929-1933, Barrie Wigmore wrote: "Municipal governments were expected to be an active countervailing force in the anticipated business downturn after the Crash. However, many municipalities were not in a position financially to bear the twin burdens of unemployment relief and capital construction…." It is easy to see why. Municipalities were spending because tax receipts rose. Since tax receipts rose, local governments could leverage growth through bond issues. Outstanding municipal bond debt doubled in the 1920s. Over the same period, federal government debt fell by 30%. With nothing learned, states and municipalities borrowed $23 billion in 2000 and $215 billion in 2007.
One reason credit rained on bubbly school committees was the ever-rising revenue stream from real estate taxes: receipts increased from $254 billion in 2000 to $421 billion in 2008. Federal Reserve Governor Frederic Mishkin dismissed the body blows of real-estate bubbles, but A.M. Hillhouse, author of Municipal Bonds: A Century of Experience, wrote in 1936: "[T]he major portion of overbonding by municipalities arises out of real estate booms…. The prize crop of boom bond troubles of all time came with the collapse of the Florida real estate speculation in 1926." In consequence, the property tax in West Palm Beach, Florida was raised to 42.5% of assessed value. This effort to balance the books failed.
At the 1933 meeting of the American Economic Association, Simpson was not a happy professor: "During this period of prosperity, real estate taxes were paid with little complaint…. [U]nder these conditions, public expenditures expanded and taxes were increased without protest…. The result has been a structure of public expenditure which has been difficult to curtail, and a volume of indebtedness whose solvency is now jeopardized on a large scale." Simpson delivered his paper at the bottom of the Depression but the number of beleaguered municipalities kept rising until 1935, when there were at least 3,252 municipal issues in default. There are at least three reasons to think current municipal problems will be worse.
First, the latest real estate bubble has probably been much bigger and more leveraged than in the 1920s. Second, expenses are not as easy to cut. The earlier retrenchment was not hamstrung by bloated government retiree pension and health benefits. Third, property assessments lag current prices. This promises to be a fierce battle. Towns want to hold the status quo so are in no hurry to tax properties at falling market values; residents do not want to fund comfortable teacher retirements when they are wondering what happened to their own pension plans.
At the One Hundred Twenty-First Annual Meeting of the American Economic Association in 2009, Professor Frederic Mishkin (who has departed the Fed and returned to Columbia University) contributed a paper, "Is Monetary Policy Effective During Financial Crises?" Whatever he had to say, may it gather dust as the world learns the lessons taught and discarded by Professor Herbert D. Simpson.
States tap stimulus as more U.S. families seek aid
Many states have used funds from the $863 billion U.S. economic stimulus plan to help give a rising number of poor families emergency cash assistance, the Government Accountability Office said on Thursday. From June 2008 to June 2009, the number of families receiving Temporary Assistance to Needy Families rose in 12 of the 21 states the GAO reviewed and dropped in six states. But, it said, the magnitude of those taking the direct cash grants varied widely, with Nevada experiencing a 22 percent increase in need and Texas seeing a 9 percent drop.
The economic stimulus plan passed last year included the largest transfer of funds from the U.S. government to states in U.S. history and the GAO found states used some of the money to help citizens living in the deepest poverty. As of October 2009, all 21 states in the GAO survey had applied to the plan's Emergency Contingency Fund for help in making the cash payments. Showing the depth of distress caused by the recession that began at the end of the 2007, the number of two-parent families receiving the aid increased in 17 states, the government's auditing arm said. The median increase was 27 percent, far more than for other types of families.
"While the number of two-parent families as a portion of all families receiving assistance was small, the increase in this population of cash assistance recipients is notable because they are the least common type of recipient group," the GAO said. The cash payments are part of the country's sweeping welfare reforms from the 1990's. Each month, eligible families receive grants that are capped, and many states will reduce or withhold those payments if adults do not meet certain work requirements. There is also a 60-months limit on how long a person may receive the cash over a lifetime.
Some states, too, have their own cash assistance programs.
Since 1996, the number of families receiving assistance has dropped, but GAO said this was not simply because poverty had eased. It said a large number of families who were eligible for the grants opted out. GAO also said that the percentage of children living in poverty fell to 16 percent in 2000 from 21 percent in 1995. But the recession pushed that rate back up to 19 percent in 2008.
Saving U.S. Water and Sewer Systems Would Be Costly
One recent morning, George S. Hawkins, a long-haired environmentalist who now leads one of the largest and most prominent water and sewer systems, trudged to a street corner here where water was gushing into the air. A cold snap had ruptured a major pipe installed the same year the light bulb was invented. Homes near the fashionable Dupont Circle neighborhood were quickly going dry, and Mr. Hawkins, who had recently taken over the District of Columbia Water and Sewer Authority despite having no experience running a major utility, was responsible for fixing the problem.
As city employees searched for underground valves, a growing crowd started asking angry questions. Pipes were breaking across town, and fire hydrants weren’t working, they complained. Why couldn’t the city deliver water, one man yelled at Mr. Hawkins. Such questions are becoming common across the nation as water and sewer systems break down. Today, a significant water line bursts on average every two minutes somewhere in the country, according to a New York Times analysis of Environmental Protection Agency data. In Washington alone there is a pipe break every day, on average, and this weekend’s intense rains overwhelmed the city’s system, causing untreated sewage to flow into the Potomac and Anacostia Rivers.
State and federal studies indicate that thousands of water and sewer systems may be too old to function properly. For decades, these systems — some built around the time of the Civil War — have been ignored by politicians and residents accustomed to paying almost nothing for water delivery and sewage removal. And so each year, hundreds of thousands of ruptures damage streets and homes and cause dangerous pollutants to seep into drinking water supplies.
Mr. Hawkins’s answer to such problems will not please a lot of citizens. Like many of his counterparts in cities like Detroit, Cincinnati, Atlanta and elsewhere, his job is partly to persuade the public to accept higher water rates, so that the utility can replace more antiquated pipes. "People pay more for their cellphones and cable television than for water," said Mr. Hawkins, who before taking over Washington’s water system ran environmental groups and attended Princeton and Harvard, where he never thought he would end up running a sewer system. "You can go a day without a phone or TV," he added. "You can’t go a day without water."
But in many cities, residents have protested loudly when asked to pay more for water and sewer services. In Los Angeles, Indianapolis, Sacramento — and before Mr. Hawkins arrived, Washington — proposed rate increases have been scaled back or canceled after virulent ratepayer dissent. So when Mr. Hawkins confronted the upset crowd near Dupont Circle, he sensed an opportunity to explain why things needed to change. It was a snowy day, and while water from the broken pipe mixed with slush, he began cheerily explaining that the rupture was a symptom of a nationwide disease, according to people present.
Mr. Hawkins — who at 49 has the bubbling energy of a toddler and the physique of an aging professor — told the crowd that the average age of the city’s water pipes was 76, nearly four times that of the oldest city bus. With a smile, he described how old pipes have spilled untreated sewage into rivers near homes. "I don’t care why these pipes aren’t working!" one of the residents yelled. "I pay $60 a month for water! I just want my toilet to flush! Why do I need to know how it works?" Mr. Hawkins smiled, quit the lecture, and retreated back to watching his crew.
On Capitol Hill, the plight of Mr. Hawkins and other utility managers has become a hot topic. In the last year, federal lawmakers have allocated more than $10 billion for water infrastructure programs, one of the largest such commitments in history. But Mr. Hawkins and others say that even those outlays are almost insignificant compared with the problems they are supposed to fix. An E.P.A. study last year estimated that $335 billion would be needed simply to maintain the nation’s tap water systems in coming decades. In states like New York, officials estimate that $36 billion is needed in the next 20 years just for municipal wastewater systems.
As these discussions unfold, particular attention is being paid to Mr. Hawkins. Washington’s water and sewer system serves the White House, many members of Congress, and two million other residents, and so it surprised some when Mr. Hawkins was hired to head the agency last September, since he did not have an engineering background or the résumé of a utility chief. In fact, after he had graduated from Harvard Law School in 1987, he spent a few years helping companies apply for permits to pollute rivers and lakes. (At night — without his firm’s knowledge — he had a second career as a professional break dancer. He met his wife, a nurse, when he fell off a platform at a dance club and landed on his head.)
But he quickly became disenchanted with corporate law. He moved to the E.P.A., where he fought polluters, and then the White House, and eventually relocated his family to a farm in New Jersey where they shoveled the manure of 35 sheep and kept watch over 175 chickens, and Mr. Hawkins began running a series of environmental groups. The mayor of Washington, Adrian M. Fenty, asked Mr. Hawkins to move to the city in 2007 to lead the Department of the Environment. He quickly became a prominent figure, admired for his ability to communicate with residents and lawmakers. When the Water and Sewer Authority needed a new leader, board members wanted someone familiar with public relations campaigns. Mr. Hawkins’s mandate was to persuade residents to pay for updating the city’s antiquated pipes.
At a meeting with board members last month, Mr. Hawkins pitched his radical solution. Clad in an agency uniform — his name on the breast and creases indicating it had been recently unfolded for the first time — Mr. Hawkins suggested raising water rates for the average resident by almost 17 percent, to about $60 a month per household. Over the coming six years, that rate would rise above $100. With that additional money, Mr. Hawkins argued, the city could replace all of its pipes in 100 years. The previous budget would have replaced them in three centuries.
The board questioned him for hours. Others have attacked him for playing on false fears. "This rate hike is outrageous," said Jim Graham, a member of the city council. "Subway systems need repairs, and so do roads, but you don’t see fares or tolls skyrocketing. Providing inexpensive, reliable water is a fundamental obligation of government. If they can’t do that, they need to reform themselves, instead of just charging more."
Similar battles have occurred around the nation. In Philadelphia, officials are set to start collecting $1.6 billion for programs to prevent rain water from overwhelming the sewer system, amid loud complaints. Communities surrounding Cleveland threatened to sue when the regional utility proposed charging homeowners for the water pollution running off their property. In central Florida, a $1.8 billion proposal to build a network of drinking water pipes has drawn organized protests.
"We’re relying on water systems built by our great-grandparents, and no one wants to pay for the decades we’ve spent ignoring them," said Jeffrey K. Griffiths, a professor at Tufts University and a member of the E.P.A.’s National Drinking Water Advisory Council. "There’s a lot of evidence that people are getting sick," he added. "But because everything is out of sight, no one really understands how bad things have become." To bring those lapses into the light, Mr. Hawkins has become a cheerleader for rate increases. He has begun a media assault highlighting the city’s water woes. He has created a blog and a Facebook page that explain why pipes break. He regularly appears on newscasts and radio shows, and has filled a personal Web site with video clips of his appearances.
It’s an all-consuming job. Mr. Hawkins tries to show up at every major pipe break, no matter the hour. He often works late into the night, and for three years he has not lived with his wife and two teenage children, who remained in New Jersey. "The kids really miss their father," said his wife, Tamara. "When we take him to the train station after a visit, my daughter in particular will sometimes cry. He’s missing out on his kids’ childhoods."
And even if Mr. Hawkins succeeds, the public might not realize it, or particularly care. Last month, the utility’s board approved Mr. Hawkins’s budget and started the process for raising rates. But even if the bigger budget reduces the frequency of water pipe breaks by half — a major accomplishment — many residents probably won’t notice. People tend to pay attention to water and sewer systems only when things go wrong.
"But this is a once-in-a-lifetime opportunity," Mr. Hawkins said recently, in between a meeting with local environmentalists and rushing home to do paperwork in his small, spartan apartment, near a place where he was once mugged at gunpoint. "This is the fight of our lifetimes," he added. "Water is tied into everything we should care about. Someday, people are going to talk about our sewers with a real sense of pride."