"Miner waiting for ride home. Each miner pays twenty-five cents a week to owner of car, Capels, West Virginia"
Ilargi: There may be no better example to express our upcoming reality than the fact that the Bank of England simultaneously 1) begins to roll down quantitative easing measures (by lowering or even halting its government bond purchases), and 2) warns the British population that living standards are about to take a major hit. In the US, the Federal Reserve is about to quit buying up mortgage-backed securities (all $1.25 trillion of which were steeped in insanity, if you ask me, just watch what happens next), but it hasn't issued a similar austerity warning. It’s probably just less politically palatable in America to say these things; and that's the only difference.
There are suggestions floating out there that private capital is ready to jump back into the MBS market. Makes you wonder what all that capital has been waiting for. It's impossible from where I'm sitting to be sure what plans, if any, exist to prop up the housing finance markets once the Fed retreats, and there's no way I’d ne surprised to see more of the same -flavor of- insanity. Are we going to see Fannie and Freddie sit on their own securities? Remember, they have a bottomless mandate since Christmas Eve 2009. Will the Federal Home Loan Banks step in? That would certainly add another -and higher- level of insanity to the mix. The reason I use the word insane is that it's been clear from the get-go that home prices supported -only- by taxpayer money are doomed to crumble; the only things achieved by the Fed's $1.25 trillion purchases are a temporary delay in home price plunges, and another giant transfer of bank and lender losses to the state (re: the population). If only for this reason the Fed would do well to warn the American people that hard times are a-coming.
Tim Geithner and Christina Romer tried to paint another rosy economic picture in front of the House Appropriations Committee ("there's progress, though it's challenging"), but even their own fellow Democrats don't buy into it anymore. American politics as a system has ceased to function, because the system has gone from representing people to representing money. And that is something that can only go well as long as the people have at least some of that money. Now that they're increasingly shut out, the system shuts down; it's inevitable. Which is why even rating agency Moody's comes with an at first glance curious warning: even the credit raters now predict pitchforks.
We've seen tear gas in Athens recently, and that was just a little taste. As you may know, I’m spending some time in France right now, and it's not hard to predict what will happen here if and when the government starts slashing salaries (as it must soon). The French simply won't understand what's happening, and mass protests will be the result, some peaceful, some violent. It’s every democratic politician's ultimate conundrum: if you don’t tell people the truth, they'll turn against you down the line; if you do tell them, they'll turn against you right away. That makes it obvious to figure out which politicians actually do get elected. Where the government is left, it will swing right, and vice versa, in ever more extreme denominations.
And yet, it's all just a prologue. There's nothing easier for politicians than to play people against each other, in order to divert -negative- attention away from themselves. And so they will.
We have a baby boomer generation that has just about all the money that's left in our societies. Their children, though, have nothing. Except for some hand-outs from their parents (I’m not talking individuals here). Unemployment among young people in many countries is downright scary, often in the 40%-50% range. No jobs, no money, no prospects. In times and places throughout history, this has brought populist dictators to the foreground, and pitchforks and torches into the streets, and there is no reason why it won't now. Today's political power is firmly in the hands of the 40-year and older crowd; they have elected incumbent politicians, and more importantly, they have the money and thus the power. The younger generation has no money and no power, but they also have nothing left to lose.
That is a dangerous combination, and how we deal with it will be what decides our futures. Our societies, already barely able to survive current debt and deficit loads, are slowly -though increasingly faster- being eaten up by the monster of unfunded liabilities: healthcare and pensions. Be it the US Medicare, Medicaid and Social Security varieties, or their European and Japanese counterparts, we're looking at ticking explosives counting down the hours, days and years. Down here at the Automatic Earth we've long said that nobody presently under 50 (and planning to retire at 65) will ever see a penny from pensions or government retirement plans (well, perhaps that one penny).
The world's pension plans have lost fortunes in the 2008/9 crash, and they will lose more going forward (they're playing double or nothing now to make up the losses). Your private pensions have entered the casino, and they ain’t never coming out again. Government obligations will not be honored, because the younger generation must and will at some time take over, through elections or otherwise, and vote themselves (again, through elections or otherwise) an ever bigger piece of the pie. And the pie will have gotten a lot smaller to boot. If time is money, and money is power, than time will be power too at some point: the young have the final advantage.
Most people are far too complacent when it comes to the consequences of a shrinking economic system. Many claim that we can easily downsize to smaller homes and smaller lives, since there's so much we don't really need anyway, that we will move in together and return to "good" conversations, growing our own tomatoes and all that. But that's just not going to happen voluntarily, not on a large and wide scale. The human mind has no reverse. It doesn't even have a steering wheel. We are built for one of two things: go forward or crash. It looks like there's no forward left before a major crash happens first. It also looks like there's not a whole lot of people who realize this.
Bank of England warns families to expect fall in living standards
Families have been warned by the Bank of England to expect an effective pay cut in the coming months because of the economic climate. In a blunt warning issued in a key report, the Bank also said that it is too early to conclude that unemployment has peaked. It said that although thus far many workers had been willing to accept pay reductions, or reluctantly to work part-time, employees may have failed to realise that the costs of goods and services are likely to rise faster than their wages in coming months. The Bank report said that one risk was that employees would be “unwilling to accept a further squeeze in real wage growth”, adding: “That could lead them to push for higher pay settlements this year. But if companies cannot afford the increase, then they may shed labour in order to contain labour costs.”
It said: “There remains a risk of further falls in employment if, for example, the recovery in demand proves more sluggish than businesses have expected. Businesses may respond to any future squeeze in profits by shedding staff.” The warning comes amid worries that Britain could fall victim to a double-dip recession, slumping backwards no sooner than the economy had escaped it. Such worries were reinforced further on Monday as a Bank policymaker and Monetary Policy Committee member Kate Barker conceded that the economy could shrink for a period this year. It added that although most of its regional experts anticipate no major change in unemployment in the coming months, there is a significant chance that, with some companies vulnerable to demands from their creditors, businesses may feel they have no option other than to cut jobs further.
The report said this “may imply further redundancies if the economy does not grow sufficiently quickly.” The report provides a “dose of realism” about the prospects for households and employment, according to John Philpott, chief economist of the Chartered Institute of Personnel and Development. “As the Bank warns, the risk of further substantial job losses remains, especially if the economic recovery is as weak as most current indicators suggest,” he said. “The likelihood of a 'jobs-light’ or, worse still, a 'jobs-loss’ recovery has been of concern to the CIPD for some time. What is equally sobering, however, is the Bank’s comment on another potential risk previously highlighted by the CIPD – that employees may be unwilling to accept the inevitability of a 'pay-tight’ recovery, with a squeeze on their real living standards.
“While pay restraint helped save jobs during the recession, the dawning realisation that this will have to continue for some considerable time if jobs are not to be lost during the recovery will test the goodwill of UK workers to the limit.” In comments which are likely to irritate the Government, the Bank also pointed out that the public spending cuts pledged by both political parties would also weigh heavy on the jobs market. Unemployment rose to 2.5 million during the recession, failing to reach the peaks of 3 million some economists had predicted. However, the Bank’s warning serves as a reminder that it is too early still to presume the worst has now passed for employment.
Moody's fears social unrest as AAA states implement austerity plans
by Ambrose Evans-Pritchard
The world's five biggest AAA-rated states are all at risk of soaring debt costs and will have to implement austerity plans that threaten "social cohnesion", according to a report on sovereign debt by Moody's. The US rating agency said the US, the UK, Germany, France, and Spain are walking a tightrope as they try to bring public finances under control without nipping recovery in the bud. It warned of "substantial execution risk" in withdrawal of stimulus.
"Growth alone will not resolve an increasingly complicated debt equation. Preserving debt affordability at levels consistent with AAA ratings will invariably require fiscal adjustments of a magnitude that, in some cases, will test social cohesion," said Pierre Cailleteau, the chief author. "We are not talking about revolution, but the severity of the crisis will force governments to make painful choices that expose weaknesses in society," he said. If countries tighten too soon, they risk stifling recovery and making maters worse by eroding tax revenues: yet waiting too is "no less risky" as it would test market patience. "At the current elevated debt levels, a rise in the government's cost of funding can very quickly render debt much less affordable."
Moody's said Britain has been slower than Spain to "rise to the challenge" and may be at greater risk of smashing through buffers of AAA creditiblity if rates suddenly rise. Spain made errors at the outset of the crisis but has since become a model pupil, pledging to cut the budget deficit from 11.4pc of GDP to 3pc by 2013. Britain is moving much more slowly, cutting its deficit to around 5.5pc of GDP over four years – though written into law, unlike Spain's pledge. At best, debt is likely to stabilise at 90pc of GDP. It could reach 100pc by 2013 if growth falters.
The Treasury said the assessment is unduly gloomy given that the maturity of UK debt is over 14 years, double the AAA average. This greatly reduces roll-over risk, giving Britain time to steady the ship. The concern is what will happen as the Bank of England stops purchasing bonds. An IMF study said quantitative easing had lopped 40 to 100 basis points off debt costs. "The discontinuation of these purchases creates upside risk to yields," said Moody's. Moody's said the saving grace for both Britain and the UK is a good a track record of belt-tightening when necessary, and a tax and spending structure that makes it easier to whittle away the debt once recovery starts. Concerns about a hung Parliament in Britain appear overblown given the broad political consensus on the need for austerity.
Connecting the Dots: Social Security Edition
by Keith Hazelton
As we have discussed on numerous occasions at Anecdotal Economics since 2006 (see links below), have written about in the dying dead-tree print media since 1999 and have worried about since 1993, the day of reckoning for Social Security drew nigh and now has come and gone, circa 2010.
Only unpleasant decisions lie ahead that will stun the second half of a Baby Boom generation of which some two-thirds essentially have no retirement savings other than the income they think their children and grandchildren will be willing to forego in future years to provide those promised Social Security benefits.
(Spoiler Alert: That isn't going to happen, although not without a protracted fight which will descend into an ugly inter-generational conflict as income-strapped Millennials, Gen-Xers, Gen-Yers and Echo Boomers refuse to pony up more of their diminishing wages that their savings-strapped parents and grandparents can recline at home beginning at age 62 and watch reruns of Dallas and Knot's Landing. Late Boomers, born between 1954 and 1964, you heard it hear first: Get ready to be employed, in some fashion, until at least age 72, maybe age 75, maybe until you are carried out feet first, whichever occurs earlier. Can you say "Welcome to Wal-Mart?")
Social Security, which as recently as a year ago had projected its reckoning day - the point at which annual outgo exceeds withholding tax revenues and interest income - would not approach until at least 2017. No worries, right mate?
Then SSA revised its forecast, advancing the crossover date (in the absence of any program changes) to 2016, a year earlier, but still a long time away in Washington, D.C. years where time virtually crawls. SSA also earlier in the fiscal year estimated its FY 2010 and FY 2011 shortfalls would be about $10 billion. Now the 2010 deficit alone may triple to nearly $30 billion.
Now the Associated Press has "discovered" the day of reckoning already has come and gone, six years early, in a folksy, oh-don't-worry-about-any-of-this piece which seems to find it more interesting that actual, printed, intra-governmental bonds, $2.5 trillion of IOUs, are kept in three-ring binders in the bottom drawer of a locked filing cabinet in West Virginia of all places than the disturbing reality of an insolvent pay-as-we-went retirement entitlement program:PARKERSBURG, W.Va. – The retirement nest egg of an entire generation is stashed away in this small town along the Ohio River: $2.5 trillion in IOUs from the federal government, payable to the Social Security Administration.
It's time to start cashing them in. For more than two decades, Social Security collected more money in payroll taxes than it paid out in benefits — billions more each year. Not anymore. This year, for the first time since the 1980s, when Congress last overhauled Social Security, the retirement program is projected to pay out more in benefits than it collects in taxes — nearly $29 billion more.
Sounds like a good time to start tapping the nest egg. Too bad the federal government already spent that money over the years on other programs, preferring to borrow from Social Security rather than foreign creditors. In return, the Treasury Department issued a stack of IOUs — in the form of Treasury bonds — which are kept in a nondescript office building just down the street from Parkersburg's municipal offices.
Now the government will have to borrow even more money, much of it abroad, to start paying back the IOUs, and the timing couldn't be worse. The government is projected to post a record $1.5 trillion budget deficit this year, followed by trillion dollar deficits for years to come.
Social Security's shortfall will not affect current benefits. As long as the IOUs last, benefits will keep flowing. But experts say it is a warning sign that the program's finances are deteriorating. Social Security is projected to drain its trust funds by 2037 unless Congress acts, and there's concern that the looming crisis will lead to reduced benefits. (All emphasis added.)
Time for some dot-connecting: From the last paragraph above, "As long as the IOUs last, benefits (to retirees) will keep flowing," shouldn't have gotten past the reporter's editor because it makes an absurd claim disguised as a fact.
Properly edited, that sentence would have read:"As long as the federal government can keep borrowing 'on-balance-sheet' money from its ever-growing cadre of domestic and international creditors to fund the Social Security deficit and Medicare deficit and fund the massive annual general budget shortfalls projected throughout the decade, the benefits will keep flowing, until such time as Congress is required to break its gilded entitlement promises."
Peter, meet Paul. And just where is that "lockbox" by the way? Oh, that's right, that guy didn't win in 2000. (Um, well he might have, but that's ancient history. Paging Mr. Gore...) As the full article correctly observes, the federal government has been "borrowing" the Social Security surplus for more than two decades. (Note: in the private sector, this is illegal. Companies are not allowed to borrow from trust funds established for employee benefits for obvious reasons. Ask your Senators or Congressional Representatives why this is so.)
Now it will borrow again to bridge the deficits, not only from ourselves but from our foreign BFFs who already own such a significant portion of our public national debt it potentially exposes America to financial blackmail, a clear and present national security threat if ever there was one.
But hey, what's $29 billion in FY 2010 against a total projected federal deficit this fiscal year of $1.5 trillion? It's a rounding error, right? Nope, and here's why. As it becomes increasingly likely that at some point within this decade the entitlement promises will have to be broken (and we already have crossed the financial Rubicon as age-62 early retirement and pre-62 disability Social Security benefit applications already are soaring far above SSA projections), the accelerating number of early retirement and disability benefit applications, to get while the gettin' is good, will swamp these modest shortfall projections and, in fact, hasten the requirement to radically restructure the entire program.
That will be the true day of reckoning, some arbitrary date, say five years from now, before which Boomer retirees will qualify for all benefits under the current program and after which, well, sorry about your luck. Judging from trial balloons this Administration has launched over the last six months about entitlement "reform," we will not be surprised when some of us are told, by accident of date of birth, we will not get "our share." Furious, yes, but suprised, no, at least we shouldn't be if we are reading correctly the scribbling of the invisible hand on the wall.
Which sets us up for the mother of all inter-generational conflicts. Late Boomers will get squeezed (consider yourself warned) and see their retirement dates kicked far into an unknowable future, but don't be mad at your children and grandchildren - the Boomers would have done the same to their parents and grandparents in a heartbeat.
And you children and grandchildren of the Boomers, wondering exactly why it is your parents and grandparents have no money saved for retirement...? Before your righteous indignation sets in, please take a moment to remember, fondly, all the Beanie Babies, Pogs, Tomagachis, Furbys, Barbies, Cabbage Patch Kids, music lessons and instruments, athletic lessons and equipment, summer adventure camps, trips to Disney World, skiing at Vail, Back Street Boys concerts, mountain bikes, X-Boxes, Nintendos, Segas and video games, CDs, DVDs, computers, stereos, televisions, cell phones, boom boxes, iPods, iPhones, 4,000 sf suburban homes, automobiles, boats, jet-skis, motorcycles, expensive-but-useless college educations, cosmetic surgery and glitzy/destination weddings which your elders showered upon you throughout your enchanted upbringings.
And don't be surprised when they (we) have to move in with you someday. Back to three generations in the same household, but look on the bright side: it might save on childcare expenses, depending on Grandma and Grandpa Boomer's schedules at Wal-Mart.
America’s Greek Crisis Is Already Here
As the Greeks tear themselves apart trying to come to grips with their precarious situation, here in the United States, people are looking at the Argives’ problems and wondering what if any lessons we can draw from their woes. The general perception seems to be that while the United States and Greece have some things in common, like big deficits, the differences between the countries are so great that there is scant to learn from the Greek crisis. But Greek stories always have something to teach us.
With the Greek prime minister in town last week, the Associated Press set about trying to draw the appropriate lesson for the United States. “Greece is a financial basket case, begging for international help,” Tom Raum asked. “Is America heading down that same road?” It’s a valid question. But to get the right answer you need the right comparison. The United States of America is not in the same shape as Greece (although, at the rate it’s going…) But the states that make up the United States? On the state level, Greece’s problems are already here. Much like Greece, much like the federal government, the state governments have racked up huge debts, have resorted to any number of budgetary gimmicks, and now that the economy has turned down, the feta’s really hitting the fan.
What the Greeks are having forced upon them — austerity — states like California and New Jersey are adopting on their own, with oftentimes painful, but necessary, results. “I will offer that ‘Greece, Iceland and Italy’ can be replaced with ‘California, New York and Illinois’ in terms of wary, hairy states of affair,” Todd Harrison wrote over at Minyanville (in the midst of pointing just how obvious Lehman’s real problems were before the bank fell apart.)
There are some people who expect, in fact, that the Greek crisis will ultimately draw the eurozone nations, and the European Union, closer, with the upshot being that Europe’s nations will look more and more like the United States’ states; semi-autonomous states that are held together by a central, federal government. France and Germany will come to the aid of their partner, which will lead them all toward, well, a more perfect union.
The other route is that France and Germany don’t come to Greece’s aid, the eurozone splinters. Greece leaves the eurozone, starts printing drachmas again, and 50 years of European unification comes undone. That can’t happen in the United States, no matter what the governor of Texas says or thinks. The Civil War pretty much ended that debate. The states, by law, also can’t go bankrupt (unlike municipalities.) So, it’s going to be some old-school belt-tightening for the Garden State, the Empire State, the Golden State, the Keystone State, the Wolverine State, and who knows how many others.
We’ve hit on this theme before. There are similarities, and differences. States, like Greece, can’t print their own money. Investors in states can be certain the federal government will step in if need be; investors in Greece still aren’t sure about how much and what kind of support France and Germany will offer. The biggest similarities, though, are in the financial ledgers. In New York, they want to raise taxes and cut services — essentially what the Greek’s are doing — to plug a $9 billion deficit. In New Jersey, the governor says “We have done every quick fix in the book that you can do, and now we are left literally holding the bag.” He’s already declared a state of emergency, and is cutting budgets like a tsunami’s on his tail. And maybe it is.
In Illinois, the governor wants to borrow $4.7 billion — and raise taxes, and fire 13,000 teachers, and cut health services, which would still leave the state with an $11 billion deficit. California, well, California’s problems last year, as spectacular as they were, were just a precursor to what’s going on across the country this year. The $787 billion stimulus included a big chunk for the states, which allowed them to paper over these problems. But that money’s not there this year, and the states, most of which by law must balance their books and none of which by law can issue their own currency, are in a tight spot, boys.
Waiting For Something To Turn Up: Europe’s Looming Pensions-based Sovereign Debt Crisis
by Edward Hugh
As Irwin Stelzer argued in a recent opinion article in the Wall Street Journal, Spain’s Prime Minister José Luis Rodríguez Zapatero seems to be an admirer of Charles Dickens’s character Mr. Micawber. When asked what he plans to do about Spain’s 11.4% fiscal deficit, first he promises to extend the retirement age, only to later tell us the measure may not be necessary. Then he promises a public-sector wage freeze, only to have his Economy Minister, Elena Salgado, say he really doesn’t mean exactly what he seems to say.
And in any event, we shouldn’t worry too much, since given that Spain is a serious country, somehow or other the fiscal deficit will be cut to 3% by 2013, even though most serious analysts consider the economic growth numbers on which the budget plans are based to have their origins more in the dreams of an Alice long lost in Wonderland than in any kind of sobre analysis of real possibilities. “We do have a plan,” deputy prime minister, Maria Teresa Fernandez de la Vega assures us, but to many that plan now seems to be little better than hoping, like the proverbial Mr. Micawber, that “something will turn up.”
The latest to draw attention, to the problematic nature of this “wait and see” approach - and to the gaping hole which is now yawning in Spain’s national balance sheet - is the credit ratings agency Fitch, who only last week warned that many Western governments now face unsustainable debt dynamics following measures taken to address the financial crisis. The agency singled out Britain, France and Spain as being in special and urgent need of outlining plans to strengthen their public finances if they don’t want to risk losing their current highly prized AAA ranking.
This strong and direct warning was issued by Brian Coulton, Head of Global Economics at Fitch, who said “High-grade sovereign governments need to articulate more credible and stronger fiscal consolidation plans during the course of 2010 to underpin confidence in the sustainability of public finances over the medium-term and their commitment to low and stable inflation. The UK, Spain and France in particular must outline more credible fiscal consolidation programmes over the coming year given the pace of fiscal deterioration and the budgetary challenges they face in stabilising public debt.”
Yet, while criticising Portugal’s gradual approach to fiscal consolidation as a matter of “concern” Fitch senior director Paul Rawkins also argued that the Spanish govenment had acted swiftly in announcing plans to consolidate public finances. Nonetheless he did still warn that the economic risks facing Spain remain very high, especially since the pace of decline in tax revenues is dramatic enough to be preoccupying, while continuing “labour market inflexibilities could well prolong the economic adjustment”.
The current problem facing Spain (and other similarly affected countries) has its roots in two quite distinct sources. In the first place measures taken to counteract the impact of the financial crisis have been inadequate and have simply produced large short term deficits. However to this short term liquidity and adjustment problem must now be added the further dimension of longer term impacts on public finances which have their origins lie in ageing populations, and the effect on economic growth of having older and smaller working-age populations.
Regarding the first, as Willem Buiter, now chief economist at Citi has pointed out, more than 40 per cent of global GDP is currently being produced in countries (overwhelmingly advanced economies) running fiscal deficits of 10 per cent of GDP or more. Over most of the last 30 years, this level fluctuated in the 0-5 per cent range and was dominated by debt from emerging economies. So the crisis marks a watershed, from which there will likely be no turning back, and in many ways could not have come at a worse moment for those countries who still have to undertake substantial pension reform to put their nation finances on a solid footing when faced with the unprecedented ageing which lies ahead.
Indeed, to take the Greek case, while the short term fiscal deficit has been the focus of most of the press attention, the longer term problem associated with the funding of Greek pensions far outweighs issues associated with the falsifying of national accounts in the early years of this century. A recent report by the European Commission found that Greek spending on pensions and health care for its ageing population, if left unchecked, would soar from just over 20 percent of GDP today to around 37 percent of G.D.P. by 2060. And Greece is simply an early warning indicator of troubles to yet to come, in larger countries like Germany, France, Spain and Italy who have all relied for decades on pay as you go type state-financed pension schemes.
Now, governments across Europe are being pressed to re-examine their commitments to providing generous pensions over extended retirements because fiscal issues associated with the downturn have suddenly pushed at least part of these previously hidden costs up to the surface. In fact, unfunded pension liabilities far outweigh the high levels of official sovereign debt. According to research by Jagadeesh Gokhale, an economist at the Cato Institute in Washington, bringing Greece’s pension obligations onto its balance sheet would show that the government’s debt is in reality equal to something like 875 percent of its gross domestic product. That would be the highest debt level in the 16-nation euro zone, and far above Greece’s official debt level of 113 percent. Other countries have obscured their total obligations as well.
In France, where the official debt level is 76 percent of economic output, total debt rises to 549 percent once all of its current pension promises are taken into account. Similarly, in Germany, the current debt level of 69 percent would soar to 418 percent. Of course, these numbers are arguable, and may well be in the excessively high range, but the fact still remains: outstanding and unfunded liabilities are huge, and would have been difficult to honour even without the present crisis. As it is, we are now in danger of spending the seedcorn which could have been harvested later on down the road.
Public opinion has yet to assimilate the seriousness of the issues involved here. As Pimco Chief Executive Mohamed El-Erian said in a recent FT Opinion article, the importance of the shock to public finances in advanced economies is not yet sufficiently appreciated and understood. With time, this issue will prove to be highly consequential. The latest Fitch report is simply another warning shot. The sooner we all recognise the, the greater the probability of our being able to stay ahead of the disruptions this adjustment to reality will cause. It is time to stop simply waiting around to see what is going to turn up, since if we do continue like this we won’t like what we eventually find.
Obama's Economic Team Gets Earful From Own Party
Democratic Congresswoman Calls Testimony 'Dismaying and Out of Touch'
Three of the Obama administration's top economic officials today said the country has bounced back from the depths of the recession but still faces serious obstacles such as high unemployment, rising foreclosures, and a soaring budget deficit. "We're seeing some encouraging signs of progress, but we face many, many daunting challenges ahead," said Treasury Secretary Tim Geithner at a House Appropriations Committee hearing this morning.
Joining Geithner at today's hearing were the other two members of the so-called "troika" of economic policymakers: Council of Economic Advisers chair Christina Romer and Office of Management & Budget director Peter Orszag. "We expect to begin seeing job gains sometime this spring," Romer said, citing the administration's forecasts that the labor market will add about 100,000 jobs per month this year, 200,000 per month next year, and 250,000 per month in 2012.
"Nevertheless," she said, "because of the severe toll the recession has taken on the labor market, unemployment is likely to remain elevated for an extended period." Romer reiterated the administration's forecast that the unemployment rate, currently at 9.7 percent, will fall to 8.9 percent at the end of next year and 7.9 percent at the end of 2012. She also repeated its predictions that the economy will grow by 3 percent this year and 4.3 percent the next two years, with inflation expected to remain low.
But in a sign of the widespread frustration about the economic downturn, Rep. Marcy Kaptur, a Democrat from Ohio, ripped into the three administration officials for not doing enough to help the unemployed. "I find your testimony dismaying and out of touch," Kaptur said, arguing that they were more focused on the deficit than job losses. "You have no urgency!" "People are becoming desperate," she said. "I am their representative. I cannot politely sit and listen to this and not feel compassion for them and expecting some from you."
Kaptur blasted the administration's foreclosure prevention plan, which to date has helped only 168,000 homeowners permanently modify their mortgages. "Your work-out programs are not working," Kaptur said. "The people who caused this mess are doing just fine&they're doing fine. The taxpayers bailed them out and my people are suffering, they're at the edge. Where is the urgency?" "The banks are not doing good enough and we are going to put substantial pressure on them&" replied Geithner.
But Kaptur quickly interrupted him: "It is pitiful, it is an embarrassment to the nation." Romer pushed back against Kaptur's criticisms. "The urgency is absolutely enormous," Romer said. "I can tell you that every single time we meet with the President, no matter what you tell him, his question is what does that mean for jobs." The three administration officials blamed the Bush administration for the country's soaring budget deficit, saying the Bush team cut taxes in 2001 and 2003 and left the country in a severe recession when Obama took office in 2009. The panel's ranking Republican replied that the rising red ink was hurting the economic recovery.
"We can agree to disagree on the cause of our economic troubles, but the fact remains that we cannot spend our way to economic health," said Rep. Jerry Lewis, R-Calif. "Until this Congress and this administration curbs its appetite for spending, our economy will continue to suffer. The simple truth is that Uncle Sam does need to go on a diet."
Housing Market Sure to Double-Dip: Meredith Whitney
The US housing market will face another retreat while mortgage-backed securities and Treasurys are likely to go through a "material" correction, Meredith Whitney, CEO of Meredith Whitney Advisory Group, told CNBC Tuesday. "The housing market surely will double dip," Whitney told "Worldwide Exchange." Government programs to support housing have been "murky" and when the modifications caused by them come to an end, a lot of supply may come to the market and that's when the real-estate market is likely to go down, she explained.
Hopes that an improvement in liquidity and continuing investment from China in US assets will prop up mortgage-backed securities (MBS) and Treasurys are exaggerated, Whitney also said. "The asset classes of MBS and Treasurys are priced for a material correction in my opinion," she said. "The only buyers of agency MBS are the Fed and banks so you see how precarious that market is." "If the Fed pulls back, that's a really big deal... because there's no substitute buyer."
Banks Model Is Broken
The Federal Reserve can't make banks start lending again because the business model financial institutions used before the crisis is broken, Whitney also said. "I don't think there's much the Fed can do to get banks to start lending again. That's a structural problem, the model is broken," Whitney told "Worldwide Exchange." Before the financial crisis erupted in 2007 banks were able to offer customers low-priced mortgages because they were making money on securitizing these mortgages and selling them on, she explained.
But now that the securitization market is effectively closed, the prices of mortgages for consumers have not risen to compensate banks for that loss of revenue, so banks have been playing defense for the past two years, Whitney added. The Federal Open Market Committee holds a meeting later Tuesday to decide on monetary policy. Fed officials have been saying that interest rates are likely to remain low for an "extended" period of time.
Whitney said she will be watching for anything regarding the Fed's stance on buying mortgage-backed securities in the statement after the meeting. "The Fed has been supporting the housing market, a third of the Fed's balance sheet is tied to mortgages," she said. "The banks aren't issuing anything (in terms of mortgages) to hold, they're issuing everything to dump on" Fannie Mae, Freddie Mac and Ginnie Mae, Whitney added.
Much of the profit banks made last year was due to their performance in capital markets and this is "unreplicable" this year, Whitney also warned. "I think that people that expect an earnings handoff to a normalized scenario are going to be disappointed," she said. "Normal will not be what it has been over the last 20 years and there's disappointment baked into that."
U.S. Housing Market Sags
by David Rosenberg
The NAHB housing index dropped two points to 15 in March despite government resources that have been expended to put a floor under the residential real estate market. This attests to the view that the problems to the sector are more secular in nature than they are cyclical.
Of major concern was the slide in the homebuyer traffic index, from 12 to 10 in March — during the era of the green shoots last spring and summer, this component surged from 13 to 17. Only three other times in history has this measure been this low.
Prospects for sale activity over the next six months also declined two points to 24 in March and this subindex leads new home sales by six months with a 76% correlation.
The S&P 500 homebuilding group has managed to rally 17% so far this year or a 1,400bps outperformance vis-à-vis the overall market. There is scant a sector that deserves such status when one takes the fundamental housing backdrop into consideration.
US housing starts drop 5.9% to 575,000 rate
Number of homes under construction falls to new low
U.S. housing starts fell about 5.9% to a seasonally adjusted annual rate of 575,000 in February as several massive snow storms hit the East and South and stalled home building, according to data released Tuesday by the Commerce Department. Starts were down in the Northeast and South, but up in the Midwest and West. Most of the decline in February was in the hugely volatile multifamily sector. Construction of single-family homes fell 0.6% to a 499,000 pace, while building of large condos and apartment buildings plunged 43%. The headline number obscures two separate markets. In the past year, starts of single-family homes are up 39%, while starts of multifamily units are down 41%. However, little has changed in the past six months in either market.
Housing starts were up 0.2% compared with February 2009, the government reported. Starts are down about 75% from the peak in 2006. "The underlying pace of home construction remains fairly steady," wrote Omair Sharif, an economist for RBS Securities. "Snow storms over the eastern part of the country were a significant factor in reducing starts in February," said Gary Bigg, an economist at Bank of America's Merrill Lynch. "With weather issues likely not a factor going forward, tight credit conditions and the elevated level of unemployment are factors that will restrain future housing activity."
Building permits -- which aren't as affected by weather events as starts are -- dropped 1.6% to 612,000 in February. Permits for single-family homes fell 0.2% to a 503,000 rate. Many economists consider the single-family permits figure to be the most reliable and important number in the release. Over time, permits and starts are highly correlated. Single-family permits are up 32% compared with February 2009. The industry has slashed production of new homes to work off a massive inventory of unsold homes. The number of homes under construction fell 2.2% to a seasonally adjusted 492,000, the lowest on record dating back to 1970.
Builders remain very pessimistic about a recovery, despite a generous tax subsidy for buyers. In March, the home builders' sentiment index dropped back to 15 from 17 in February. Builders face tough competition from foreclosures of existing homes, and buyers remain cautious about the job market. See full story on the builders' sentiment index. The government cautions that its monthly housing data are volatile and subject to large sampling and other statistical errors. In most months, the government can't be sure whether starts increased or decreased. In February, for instance, the standard error for starts was plus or minus 10%. Large revisions are common. The standard error for monthly building permits data is much lower at plus or minus 1%.
It can take four months for a new trend in housing starts to emerge from the data. In the past four months, housing starts have averaged 585,000 annualized, up from 572,000 in the four months ending in January. The February estimate of 575,000 total starts was in line with the 568,000 rate expected by the median forecast of economists surveyed by MarketWatch. Read our complete economic calendar and consensus forecast. January's starts pace was revised higher to 611,000 from 591,000 previously reported. Read the full report on the government's website.
Albert Edwards Predicts Deflation Followed By Double-Digit Inflation As "Governments Opt To Default, And Monetization Is Policy Lever of First Resort
As if we needed any more confirmation that deflationary pressures continue to prevail and to swamp the broader economy, here is SocGen's Albert Edwards with his most recent (and humorous: we had no clue that the "UK?s ONS statistical office has just decided to throw canned fizzy drinks out of the UK?s CPI basket and replace them with small bottles of mineral water") menu prescriptions for the near- to mid-term future.
First an appetizer, here is a look at US consumer leverage trends. Yes, good point: what leverage?
Last week's Flow of Funds report from the Fed showed that US total credit continued to disappear down the plughole, despite the government's best efforts to inflate us back to prosperity (see chart below). The current recovery, based in very large part on the end of de-stocking, simply cannot be sustained while credit is disappearing at this debilitating dehydrating rate.
The recently released Q4 Flow of Funds data allowed economists to get a full view of the 2009 data. It was ugly. Most shockingly, the household sector shrank its borrowing for the seventh quarter in a row – with minimal signs of any abatement to the process. Combined with continued rapid balance sheet shrinkage in both the corporate and financial sectors, total domestic debt contracted for the fourth quarter in a row (see front page chart). Now, we might be getting used to such news, but it is always worth remembering that, prior to the global meltdown, even one quarter of total domestic debt shrinkage was like seeing a black swan with some pink dots thrown in for good measure.
Some statistical observations: while the process of deleveraging is on the right path, it has a long path to go. Just compare household debt between the lofty dot com days and today.
With nominal GDP actually managing to inch up some 0.8% in the year to Q4 2009, the economy managed its first baby step along the long and winding road to normality, with US debt dipping under 350% of GDP (see chart below). Household leverage has returned to 94% from its peak of 96% in both 2007 and 2008. But consider this: at the peak of the Nasdaq bubble, household leverage was just shy of 70%. There is a very, very long way to go.
The entre: Japenese "Ice-Age" Melange.
Many clients ask how we will know when the deleveraging process is over or whether there is a "right" debt/income ratio. We will know when the deleveraging process has ended when we see an end to the unprecedented pace of decline in bank lending (see chart below). This process took three years in the early 1990s. Expect at least a decade of Japan-like Ice-Age pain.
Desert: Sovereign Debt Flambe.
Ultimately, as my colleague Dylan Grice writes, I think we head back to double-digit inflation rates as governments opt to default. I certainly again expect to see CPI inflation above 25% in the UK and indeed in most developed nations in my lifetime ? I have happy memories of the three-day week and doing my homework by candlelight. In the near term, however, the deflationary quicksand will suck us ever lower until we suffocate. A key driver for underlying inflation remains unit labour costs. While unit labour costs decline at an unprecedented rate, they are sucking us inevitably into a Fisherian, debt-deflation spiral. Only then will we see how far policymakers are willing to go to debauch the currency. Last year saw them cross the Rubicon. Monetisation is now the policy lever of first resort.
In summary, the menu for the next 5 years: Hyperdeflation followed by rampant inflation, with a smattering of stagflation thrown in for good measure. Served chilled. Enjoy.
Japan Eases Monetary Policy to Fight Deflation
In a bid to shore up a deflation-plagued economy, Japan’s central bank eased monetary policy further on Wednesday by boosting a bank-loan program, setting the world’s second-largest economy on a divergent path from other industrialized nations. Central banks around the world have in recent weeks mulled rolling back stimulus steps put in place during the global economic crisis, gradually shrinking excess liquidity in their banking systems. The U.S. Federal Reserve said Tuesday it will let a mortgage-security purchase program expire at the end of March.
But in Japan — where prices have remained sluggish amid a lackluster recovery from its worst recession since World War II — the government has urged monetary authorities to further stimulate the economy by flooding the banking sector with cash. Japan is also leaning on monetary policy because its public debt load, the highest among industrialized countries, makes it reluctant to spend more money on public works projects and other government stimulus programs.
In a 5-2 vote at a policy meeting on Wednesday, the Bank of Japan’s board decided to double a bank-loan program aimed at boosting liquidity in the Japanese economy to 20 trillion yen ($222 billion). The fixed-rate loans are available for three months. The board voted unanimously to keep the bank’s main policy rate on hold at 0.1 percent. “The latest step is additional monetary easing. We are employing the available tools to contribute to improving the economy and overcoming deflation, Gov. Masaaki Shirakawa said at a press conference. But Mr. Shirakawa struck a note of caution, saying the latest step alone “would not clear up the cloud hanging over the Japanese economy.
One way central banks have spurred economic activity has been to lower interest rates, which makes it cheaper for businesses and consumers to borrow money to invest or spend, and less attractive for them to save. But with interest rates already close to zero, Japan is being forced to resort to other measures. Japan pursued a zero-interest rate policy from 2001 to 2006, when it gradually started raising rates, hitting 0.5 percent in early 2007. But in late 2008, the central bank again started to slash rates as Japan’s economy was hit by the effects of the global economic crisis.
With Wednesday’s move, Japan’s financial institutions will be able to borrow a combined total of 20 trillion yen for three months at a fixed rate of 0.1 percent. Still this most recent action could be offset by the end of a separate credit facility that provides unlimited loans, backed by collateral, to commercial banks. “The BOJ’s decision to expand the lending program may signal that Japan still can’t exit from the emergency mode and heads in the opposite direction from the global trend,” Mari Iwashita, chief market economist at Nikko Cordial Securities Inc. in Tokyo, told Bloomberg News.
Moreover, Japan’s efforts may have little impact because banks are struggling to boost credit growth amid a weak economy, despite ample liquidity — a situation economists call a “liquidity trap.” Japan is not expected to start tightening monetary policy soon. Even as Japan’s economy shows signs of recovery — its economy has grown for three straight quarters — prices continue to fall. Consumer prices dipped for an 11th month in January, while bank lending has fallen for three straight months amid sluggish demand for credit.
A major problem facing Japan is deflation, or a general fall in prices due to a lack of demand. Falling prices makes consumers even more reluctant to spend, because any purchase is likely to be cheaper in the future. Deflation also depresses investment by corporations, because falling prices make it difficult to predict returns and make debts harder to pay off. Finance Minister Naoto Kan has called on the central bank to do more to fight deflation. This week, he said he hoped Japan’s economy would beat deflation this year.
Mr. Kan applauded the central bank on Wednesday, saying the move showed it is “stepping up efforts to fight deflation.” “It is not hard to imagine that the government’s strong hope that Japan can beat deflation is behind the monetary loosening,” Takehiro Sato, a Tokyo-based economist at Morgan Stanley, wrote in a report. “If the government and Bank of Japan can present a unified front in fighting deflation, they might be able to send a positive message to markets,” Mr. Sato said.
But other analysts remain skeptical. The central bank has “made it clear that it does not believe that it has the tools to bring deflation to an early end,” Richard Jerram, Japan economist for Macquarie, said in a report. “As a result, it seems prudent to expect another extended period of price declines.” Gov. Shirakawa warned that beating deflation would be a long, arduous task. “It will take a long time for Japan to overcome deflation. We have to calmly accept that it will take time for improvements,” Mr. Shirakawa said. “ We will be persistent in our monetary policy,” he said.
Fed to End Mortgage-Purchase Program
The Federal Reserve said it will end, as planned, one of its main supports for the U.S. economy—purchases of $1.25 trillion of mortgage-backed securities—allowing a nascent economic recovery to stand with less government support. Fed officials ended a meeting of their policy committee Tuesday noting the economy is improving, but signaled that it will be at least several more months before they raise short-term interest rates from near-zero levels.
"Economic activity has continued to strengthen," the Fed said in a statement. "The labor market is stabilizing," it continued. "Inflation is likely to be subdued for some time." Slowly improving growth, low inflation and more normal credit markets have led Fed Chairman Ben Bernanke to unwind many Fed emergency-rescue efforts while putting off raising rates. The Fed will complete the mortgage-backed securities purchases by the end of March, winding down a program that it and many economists believe played an important role in preventing a much deeper recession. The purchases helped drive up the value of these securities and thus drove down mortgage interest rates and helped financial markets.
The March 9, 2009, bottom in the Dow Jones Industrial Average came just a few days before word of the Fed's big mortgage program began circulating in financial markets a year ago. Some analysts have worried that the end to the Fed's mortgage buying could raise mortgage rates. So far that hasn't happened. Rates on 30-year mortgages have fallen to around 5.05% from 5.28% at the start of the year, according to research firm HSH Associates, even as Fed officials telegraphed the program would end soon. Other long-term interest rates have been stable. Yields on 10-year Treasury notes have hovered between 3.6% and 3.8% this year.
"Mortgage rates won't move appreciably," said Scott Simon, a managing director at Pacific Investment Management Company, a big mortgage securities investor. He said private investors, who stepped aside when the Fed jumped into the market, are ready to return. It is not as though credit is all of the sudden going to become much more difficult to get. The big problem for the housing market is unemployment," Mr. Simon said.
Still, the end of the program comes at a delicate moment. Many housing indicators have been flat to softer in recent months, in part because of bad weather, and could be vulnerable to a shock.
With the conclusion of mortgage purchases, attention at the Fed is shifting toward the potentially divisive decision of when to raise interest rates. The benchmark federal funds rate, a rate banks charge each other for overnight loans, has been pinned between zero and 0.25% since December 2008. Futures markets put high odds on a rate increase to 0.5% by November. In its statement, the Fed retained its year-old vow to keep short-term rates remain "exceptionally low" for an "extended period," which means at least several more months.
Fed officials have begun debating how and when to change that wording to signal rate increases could be coming. Details of the debate could be spelled out when minutes of Tuesday's meeting are released next month. If the Fed raises rates too soon or too aggressively, it could undermine the recovery. But if it waits too long, it could fuel inflation. Worried that low rates may spur inflation, Kansas City Fed President Thomas Hoenig was again the lone dissenter Tuesday. He wanted to drop the "extended period" language as he did at the January meeting.
But with many measures of inflation still slowing and the unemployment rate at a lofty 9.7%, other officials are reluctant to unsettle markets by removing those key words yet. Fed officials have other tough decisions to make. Over time they want to shrink their now massive holdings of mortgage securities. About $200 billion worth will run off by the end of 2011 as they mature or get paid off by borrowers. Officials are considering whether to gradually sell some of the rest. They are also debating whether to allow some of their $776 billion in Treasury securities holdings to mature without being reinvested, which they could do to shrink their overall holdings.
PIMCO: End of mortgage buys form of tightening
The end of the Federal Reserve's program of purchasing $1.25 trillion of mortgage-backed securities at the end of March is a form of tightening monetary policy, the chief of the largest U.S. bond fund manager said on Tuesday. Mohamed El-Erian, chief executive and co-chief investment officer of Pacific Investment Management Co, or PIMCO, said the end of the Fed's mortgage program, one of the U.S. central bank's major support programs, signals a form of credit tightening.
The Federal Reserve Open Market Committee's statement on Tuesday "met market expectations on the three key aspects of leaving interest rates unchanged, maintaining dovish language about future policy moves and allowing the special programs to lapse," El-Erian told Reuters. By the end of March, the Fed plans to have bought $1.25 trillion worth of mortgage-backed securities and about $175 billion worth of agency debt -- a process economists and investors have called "quantitative easing."
The unwind of the program weans the U.S. economy from government support at a time when the Fed believes the recovery is gathering some strength. In fact, Fed officials said the overall economy is improving. In their statement, they said: "Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing," it said.
That said, there were words of caution in the Fed's statement, which accompanied the decision to renew its pledge to keep interest rates near zero for an "extended period." The Fed said household spending is expanding at a moderate rate "but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit." El-Erian said the statement confirms that the resurgence in economic activity from the global financial crisis is "likely to be bumpy and generally disappointing when compared to previous recoveries."
Big Bailout Banks Slashed New Lending In January
The Treasury Department said Monday that new lending plummeted in January at the nine largest banks that have yet to repay their taxpayer bailouts. Treasury's monthly survey of bank lending shows overall new loan origination dropped 35 percent from December's level. Treasury says the drop "may be partially explained by large increases" in late 2009. The survey also shows that average loan balances at the nine banks were 2 percent higher than in December – bringing them to their highest level since September. The nine banks are: Citigroup Inc., Comerica Inc., Fifth Third Bancorp, Hartford Financial Services Group Inc., KeyCorp, Marshall & Ilsley Corp., PNC Financial Services Group Inc., Regions Financial Corp. and Suntrust Banks Inc.
Increasing lending to consumers and small businesses was one of Congress' stated goals when it passed the $700 billion financial bailout in October 2008. Treasury said this is the last time it will publish a summary analysis of the bank survey because "aggregate month to month changes are no longer meaningful." The nine banks surveyed in January held 17 percent of industry assets at the end of 2009. When the survey was first conducted in November 2008, it included the 22 largest banks holding bailout money. Those banks held 61 percent of industry assets.
There's Deep Fraud On Wall Street, And Goldman's Behavior In Greece Is Just The Tip
by Senator Ted Kaufmann
Mr. President, last Thursday, the bankruptcy examiner for Lehman Brothers Holdings Inc. released a 2,200 page report about the demise of the firm which included riveting detail on the firm’s accounting practices. That report has put in sharp relief what many of us have expected all along: that fraud and potential criminal conduct were at the heart of the financial crisis. Now that we’re beginning to learn many of the facts, at least with respect to the activities at Lehman Brothers, the country has every right to be outraged. Lehman was cooking its books, hiding $50 billion in toxic assets by temporarily shifting them off its balance sheet in time to produce rosier quarter-end reports. According to the bankruptcy examiner's report, Lehman Brothers’ financial statements were "materially misleading" and its executives had engaged in "actionable balance sheet manipulation." Only further investigation will determine whether the individuals involved can be indicted and convicted of criminal wrongdoing.
According to the examiner’s report, Lehman used accounting tricks to hide billions in debt from its investors and the public. Starting in 2001, that firm began abusing financial transactions called repurchase agreements, or “repos.” Repos are basically short-term loans that exchange collateral for cash in trades that may be unwound as soon as the next day. While investment banks have come to over-rely upon repos to finance their operations, they are neither illegal nor questionable; assuming, of course, they are clearly accounted for.
Lehman structured its repo agreements so that the collateral was worth 105 percent of the cash it received – hence, the name “Repo 105.” As explained by the New York Times' DealBook, “That meant that for a few days – and by the fourth quarter of 2007 that meant end-of-quarter – Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was.” Even worse, Lehman’s management trumpeted how the firm was decreasing its leverage so that investors would not flee from the firm. But inside Lehman, according to the report, someone described the Repo 105 transactions as “window dressing,” a nice way of saying they were designed to mislead the public.
Ernst & Young, Lehman's outside auditor, apparently became “comfortable” with, and never objected to, the Repo 105 transactions. And while Lehman never could find a U.S. law firm to provide an opinion that treating the Repo 105s as a sale for accounting purposes was legal, the British law firm Linklaters provided an opinion letter under British law that they were sales and not mere financing arrangements. And so Lehman ran the transactions through its London subsidiary and used several different foreign bank counterparties.
Mr. President, the SEC and Justice Department should pursue a thorough investigation, both civil and criminal, to identify every last person who had knowledge that Lehman was misleading the public about its troubled balance sheet – and that means everyone from the Lehman executives, to its board of directors, to its accounting firm, Ernst & Young. Moreover, if the foreign bank counterparties who purchased the now infamous "Repo 105s" were complicit in the scheme, they should be held accountable as well.
Returning the Rule of Law to Wall Street
Mr. President, it is high time that we return the rule of law to Wall Street, which has been seriously eroded by the deregulatory mindset that captured our regulatory agencies over the past 30 years, a process I described at length in my speech on the floor last Thursday. We became enamored of the view that self-regulation was adequate, that “rational” self-interest would motivate counterparties to undertake stronger and better forms of due diligence than any regulator could perform, and that market fundamentalism would lead to the best outcomes for the most people. Transparency and vigorous oversight by outside accountants were supposed to keep our financial system credible and sound.
The allure of deregulation, instead, led to the biggest financial crisis since 1929. And now we’re learning, not surprisingly, that fraud and lawlessness were key ingredients in the collapse as well. Since the fall of 2008, Congress, the Federal Reserve and the American taxpayer have had to step into the breach – at a direct cost of more than $2.5 trillion – because, as so many experts have said: "We had to save the system." But what exactly did we save?
First, a system of overwhelming and concentrated financial power that has become dangerous. It caused the crisis of 2008-2009 and threatens to cause another major crisis if we do not enact fundamental reforms. Only six U.S. banks control assets equal to 63 percent of the nation’s gross domestic product, while oversight is splintered among various regulators who are often overmatched in assessing weaknesses at these firms.
Second, a system in which the rule of law has broken yet again. Big banks can get away with extraordinarily bad behavior – conduct that would not be tolerated in the rest of society, such as the blatant gimmicks used by Lehman, despite the massive cost to the rest of us.
The Lessons of Lehman Brothers and Other Examples
Mr. President, what lessons should we take from the bankruptcy examiner’s report on Lehman, and from other recent examples of misleading conduct on Wall Street? I see three.
First, we must undo the damage done by decades of deregulation. That damage includes financial institutions that are “too big to manage and too big to regulate” (as former FDIC Chairman Bill Isaac has called them), a “wild west” attitude on Wall Street, and colossal failures by accountants and lawyers who misunderstand or disregard their role as gatekeepers. The rule of law depends in part on manageably-sized institutions, participants interested in following the law, and gatekeepers motivated by more than a paycheck from their clients.
Second, we must concentrate law enforcement and regulatory resources on restoring the rule of law to Wall Street. We must treat financial crimes with the same gravity as other crimes, because the price of inaction and a failure to deter future misconduct is enormous.
Third, we must help regulators and other gatekeepers not only by demanding transparency but also by providing clear, enforceable “rules of the road” wherever possible. That includes studying conduct that may not be illegal now, but that we should nonetheless consider banning or curtailing because it provides too ready a cover for financial wrongdoing. The bottom line is that we need financial regulatory reform that is tough, far-reaching, and untainted by discredited claims about the efficacy of self-regulation.
The Fraud Enforcement and Recovery Act
When Senators Leahy, Grassley and I introduced the Fraud Enforcement and Recovery Act (FERA) last year, our central objective was restoring the rule of law to Wall Street. We wanted to make certain that the Department of Justice and other law enforcement authorities had the resources necessary to investigate and prosecute precisely the sort of fraudulent behavior allegedly engaged in by Lehman Brothers. We all understood that to restore the public's faith in our financial markets and the rule of law, we must identify, prosecute, and send to prison the participants in those markets who broke the law. Their fraudulent conduct has severely damaged our economy, caused devastating and sustained harm to countless hard-working Americans, and contributed to the widespread view that Wall Street does not play by the same rules as Main Street.
FERA, signed into law in May, ensures that additional tools and resources will be provided to those charged with enforcement of our nation's laws against financial fraud. Since its passage, progress has been made, including the President’s creation of an interagency Financial Fraud Enforcement Task Force, but much more needs to be done. Many have said we should not seek to "punish" anyone, as all of Wall Street was in a delirium of profit-making and almost no one foresaw the sub-prime crisis caused by the dramatic decline in housing values. But this is not about retribution. This is about addressing the continuum of behavior that took place – some of it fraudulent and illegal -- and in the process addressing what Wall Street and the legal and regulatory system underlying its behavior have become.
As part of that effort, we must ensure that the legal system tackles financial crimes with the same gravity as other crimes. When crimes happened in the past (as in the case of Enron, when aided and abetted by, among others, Merrill Lynch, and not prevented by the supposed gatekeepers at Arthur Andersen), there were criminal convictions. If individuals and entities broke the law in the lead up to the 2008 financial crisis (such as at Lehman Brothers, which allegedly deceived everyone, including the New York Fed and the SEC), there should be civil and criminal cases that hold them accountable.
If we uncover bad behavior that was nonetheless lawful, or that we cannot prove to be unlawful (as may be exemplified by the recent reports of actions by Goldman Sachs with respect to the debt of Greece), then we should review our legal rules in the US and perhaps change them so that certain misleading behavior cannot go unpunished again. This will not be easy. As the Wall Street Journal’s “Heard on the Street” noted last week, “Give Wall Street a rule and it will find a loophole.” Systemic issues in Uncovering and Prosecuting FraudThis confirms what I heard On December 9 of last year, when I convened an oversight hearing on FERA. As that hearing made clear, unraveling sophisticated financial fraud is an enormously complicated and resource-intensive undertaking, because of the nature of both the conduct and the perpetrators.
Rob Khuzami, head of the SEC’s enforcement division, put it this way during the hearing: “White-collar area cases, I think, are distinguishable from terrorism or drug crimes, for the primary reason that, often, people are plotting their defense at the same time they're committing their crime. They are smart people who understand that they are crossing the line, and so they are papering the record or having veiled or coded conversations that make it difficult to establish a wrongdoing.” In other words, Wall Street criminals not only possess enormous resources but also are sophisticated enough to cover their tracks as they go along, often with the help, perhaps unwitting, of their lawyers and accountants.
Assistant Attorney General Lanny Breuer and Khuzami, along with Assistant FBI Director Kevin Perkins, all emphasized at the hearing the difficulty of proving these cases from the historical record alone. The strongest cases come with the help of insiders, those who have first-hand knowledge of not only conduct but also motive and intent. That’s why I’ve applauded the efforts of the SEC and DOJ to use both carrots and sticks to encourage those with knowledge to come forward.
At the conclusion of that hearing in December, I was confident that our law enforcement agencies were intensely focused on bringing to justice those wrongdoers who brought our economy to the brink of collapse.
Going forward, we need to make sure that those agencies have the resources and tools they need to complete the job. But we are fooling ourselves if we believe that our law enforcement efforts, no matter how vigorous or well funded, are enough by themselves to prevent the types of destructive behavior perpetrated by today’s too-big, too-powerful financial institutions on Wall Street.
Is Lehman Brothers an Isolated Example?
Mr. President, I’m concerned that the revelations about Lehman Brothers are just the tip of the iceberg. We have no reason to believe that the conduct detailed last week is somehow isolated or unique. Indeed, this sort of behavior is hardly novel. Enron engaged in similar deceit with some of its assets. And while we don’t have the benefit of an examiner’s report for other firms with a business model like Lehman’s, law enforcement authorities should be well on their way in conducting investigations of whether others used similar “accounting gimmicks” to hide dangerous risk from investors and the public.
The Case of Greece
At the same time, there are reports that raise questions about whether Goldman Sachs and other firms may have failed to disclose material information about swaps with Greece that allowed the country to effectively mask the full extent of its debt just as it was joining the European Monetary Union (EMU). We simply do not know whether fraud was involved, but these actions have kicked off a continent-wide controversy, with ramifications for U.S. investors as well.
In Greece, the main transactions in question were called cross-currency swaps that exchange cash flows denominated in one currency for cash flows denominated in another. In Greece’s case, these swaps were priced “off-market,” meaning that they didn’t use prevailing market exchange rates. Instead, these highly unorthodox transactions provided Greece with a large upfront payment (and an apparent reduction in debt), which they then paid off through periodic interest payments and finally a large “balloon” payment at the contract’s maturity. In other words, Goldman Sachs allegedly provided Greece with a loan by another name.
The story, however, does not end there. Following these transactions, Goldman Sachs and other investment banks underwrote billions of Euros in bonds for Greece. The questions being raised include whether some of these bond offering documents disclosed the true nature of these swaps to investors, and, if not, whether the failure to do so was material. These bonds were issued under Greek law, and there is nothing necessarily illegal about not disclosing this information to bond investors in Europe.
At least some of these bonds, however, were likely sold to American investors, so they may therefore still be subject to applicable U.S. securities law. While “qualified institutional buyers” (QIBs) in the U.S. are able to purchase bonds (like the ones issued by Greece) and other securities not registered with the SEC under Securities Act of 1933, the sale of these bonds would still be governed by other requirements of U.S. law. Specifically, they presumably would be subject to the prohibition against the sale of securities to U.S. investors while deliberately withholding material adverse information.
The point may be not so much what happened in Greece, but yet again the broader point that financial transactions must be transparent to the investing public and verified as such by outside auditors. AIG fell in large part due to its credit default swap exposure, but no one knew until it was too late how much risk AIG had taken upon itself. Why do some on Wall Street resist transparency so? Lehman shows the answer: everyone will flee a listing ship, so the less investors know, the better off are the firms which find themselves in a downward spiral. At least until the final reckoning.
Who’s Responsible? The Role of Congress, Regulators, Accountants and Lawyers
Who’s to blame for this state of affairs, where major Wall Street firms conclude that hiding the truth is okay? Well, there’s plenty of blame to go around. As I said previously, both Congress and the regulators came to believe that self-interest was regulation enough. In the now-immortal words of Alan Greenspan, “Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity -- myself especially -- are in a state of shocked disbelief.” The time has come to get over the shock and get on with the work.
What about the professions? Accountants and lawyers are supposed to help insure that their clients obey the law. Indeed, they often claim that simply by giving good advice to their clients, they’re responsible for far more compliance with the law than are government investigators. That claim rings hollow, however, when these professionals now seem too often focused on helping their clients get around the law. Experts like Professor Peter Henning of Wayne State University Law School, looking at the Lehman examiner’s report on the Repo 105 transactions, are stunned that the accountant Ernst & Young never seemed to be troubled in the least about it. Of course, the fact that a Lehman executive was blowing a whistle on the practice in May 2008 did not change anything, other than to cause some discomfort in the ranks. While saying he was confident he could clear up the whistleblower’s concerns, the lead partner for Lehman at Ernst & Young wrote that the letter and off-balance sheet accounting issues were "adding stress to everyone."
As Professor Henning notes, one of the supposed major effects of the Sarbanes-Oxley Act was to empower the accountants to challenge management and ensure that transactions were accounted for properly. Indeed, it was my predecessor, then-Senator Biden, who was the lead author of the provision requiring the CEO and CFO to attest to the accuracy of financial statements, under penalty of criminal sanction if they knowingly or willfully certified materially false statements. I don't believe this is a failure of Sarbanes-Oxley. A law is not a failure simply because some people subsequently violate it.
I am deeply disturbed at the apparent failure of some in the accounting profession to change their ways and truly undertake the profession's role as the first line of defense (the gatekeeper) against accounting fraud. In just a few years time since the Enron-related death of the accounting firm Arthur Andersen, one might have hoped that "technically correct" was no longer a defensible standard if the cumulative impression left by the action is grossly misleading. But apparently that standard as a singular defense is creeping back into the profession.
The accountants and lawyers weren't the only gatekeepers. If Lehman was hiding balance sheet risks from investors, it was also hiding them from rating agencies and regulators, thereby allowing it to delay possible ratings downgrades that would increase its capital requirements. The Repo 105 transactions allowed Lehman to lower its reported net leverage ratio from 17.3 to 15.4 for the first quarter of 2008, according to the examiner's report. It was bad enough that the SEC focused on a misguided metric like net leverage when Lehman's gross leverage ratio was much higher and more indicative of its risks. The SEC's failure to uncover such aggressive and possibly fraudulent accounting, as was employed on the Repo 105 transactions, provides a clear indication of the lack of rigor of its supervision of Lehman and other investment banks.
The SEC in years past allowed the investment banks to increase their leverage ratios by permitting them to determine their own risk level. When that approach was taken, it should have been coupled with absolute transparency on the level of risk. What the Lehman example shows is that increased leverage without the accountants and regulators and credit rating agencies insisting on transparency is yet another recipe for disaster.
Mr. President, last week’s revelations about Lehman Brothers reinforce what I’ve been saying for some time. The folly of radical deregulation has given us financial institutions that are too big to fail, too big to manage, and too big to regulate. If we have any hope of returning the rule of law to Wall Street, we need regulatory reform that addresses this central reality.
As I said more than a year ago: "At the end of the day, this is a test of whether we have one justice system in this country or two. If we don’t treat a Wall Street firm that defrauded investors of millions of dollars the same way we treat someone who stole 500 dollars from a cash register, then how can we expect our citizens to have faith in the rule of law? For our economy to work for all Americans, investors must have confidence in the honest and open functioning of our financial markets. Our markets can only flourish when Americans again trust that they are fair, transparent, and accountable to the laws."
The American people deserve no less.
At Lehman, Watchdogs Saw It All
by Andrew Ross Sorkin
Almost two years ago to the day, a team of officials from the Securities and Exchange Commission and the Federal Reserve Bank of New York quietly moved into the headquarters of Lehman Brothers. They were provided desks, phones, computers — and access to all of Lehman’s books and records. At any given moment, there were as many as a dozen government officials buzzing around Lehman’s offices. These officials, whose work was kept under wraps at the time, were assigned by Timothy Geithner, then president of the New York Fed, and Christopher Cox, then the S.E.C. chairman, to monitor Lehman in light of the near collapse of Bear Stearns.
Similar teams from the S.E.C. and the Fed moved into the offices of Goldman Sachs, Morgan Stanley, Merrill Lynch and others. There were plenty of reasons to send in these SWAT teams. With investors on edge about the veracity of valuations on Wall Street — and with hedge fund managers like David Einhorn publicly questioning Lehman’s numbers — the government examiners rifled through Lehman’s accounts. They also interviewed executives about various decisions, and previewed the quarterly earnings reports. Yet now, two years later, we learn through a 2,200-page report from Lehman’s bankruptcy examiner, Anton R. Valukas, that the firm was taking a creative approach with its valuations and accounting.
One crucial move was to shift assets off its books at the end of each quarter in exchange for cash through a clever accounting maneuver, called Repo 105, to make its leverage levels look lower than they were. Then they would bring the assets back onto its balance sheet days after issuing its earnings report. And where was the government while all this “materially misleading” accounting was going on? In the vernacular of teenage instant messaging, let’s just say they had a vantage point as good as POS (parent over shoulder).
The new mystery is why it took this long for anyone to raise a red flag. “Even though Lehman dressed up its accounts for the great unwashed public, it did not try to fool the authorities,” Yves Smith, the author of “ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism,” wrote on her blog last week. “Its game-playing was in full view.” Indeed, it now appears that the federal government itself either didn’t appreciate the significance of what it saw (we’ve seen that movie before with regulators waving off tips about Bernard L. Madoff). Or perhaps they did appreciate the significance and blessed the now-suspect accounting anyway.
Oddly, when the bankruptcy examiner asked Matthew Eichner of the S.E.C., who was involved with supervising firms like Lehman, whether the agency focused on leverage levels, he answered that “knowledge of the volumes of Repo 105 transactions would not have signaled to them ‘that something was terribly wrong,’ ” according to the examiner’s report. There’s a lot riding on the government’s oversight of these accounting shenanigans. If Lehman Brothers executives are sued civilly or prosecuted criminally, they may actually have a powerful defense: a raft of government officials from the S.E.C. and Fed vetted virtually everything they did.
On top of that, Lehman’s outside auditor, Ernst & Young, and a law firm, Linklaters, signed off on the transactions. The problems at Lehman raise even larger questions about the vigilance of the S.E.C. and Fed in overseeing the other Wall Street banks as well. “I’m concerned that the revelations about Lehman Brothers are just the tip of the iceberg,” Senator Ted Kaufman wrote in a speech he was preparing to give Tuesday on the Senate floor. “We have no reason to believe that the conduct detailed last week is somehow isolated or unique. Indeed, this sort of behavior is hardly novel.”
Here’s how Repo 105 worked in simple terms: At the end of each quarter, to reduce its all-important leverage levels, Lehman would “sell” assets (typically highly liquid government securities) to another firm in exchange for cash, which it would use to pay down its debt. The assets were typically worth 105 percent of the cash Lehman received. Several days later, after reporting its earnings, it would buy the assets back. Normally, this would be considered a loan, or repurchase agreement, but instead it was booked as a sale.
Huge piles of cash were moving in and out. According to the examiner’s report, “Lehman reduced its net balance sheet at quarter-end through its Repo 105 practice by approximately $38.6 billion in fourth quarter 2007, $49.1 billion in first quarter 2008, and $50.38 billion in second quarter 2008.” Perhaps tellingly, there is no evidence that Lehman kept two sets of books or somehow tried to hide what it was doing from regulators. The bankruptcy examiner spent over a year searching through virtually every e-mail message at the firm and didn’t say he found any evidence of a cover-up.
That may explain why so few at the firm seemed to think that what they were doing was wrong, based on the e-mail traffic reviewed by the examiner. They talked openly about Repo 105. And while some apparently felt queasy about it, they also repeatedly said that it was legal (there are no e-mail messages from Richard Fuld Jr. or any senior executive directing another executive to use Repo 105 to mask earnings). Lehman’s shell game didn’t come to light until June 2008, when a lower-level executive named Matthew Lee sent a letter to management raising a host of questions about the firm’s practices. (By the way, the S.E.C. and Fed were still working inside the building at this point.)
What the examiner didn’t report, however, was that Mr. Lee started raising questions about Repo 105 only when it became clear that he was being replaced in his role, according to people briefed on the matter. Indeed, Mr. Lee’s original letter to management did not mention the use of Repo 105. Whatever the case, in an age calling for more accountability on Wall Street, it seems we could use some in Washington too.
Rachel Maddow Questions Geithner About Role At New York Fed: 'Where Were You?'
Treasury Secretary Timothy Geithner described the nation's financial crisis as "deeply unfair" to average Americans Tuesday, during an interview with Rachel Maddow. Geithner told Maddow that because of American suffering, he felt a "deep sense of responsibility" to reform the nation's financial system:GEITHNER: I think this is a just war. I think it's a necessary and important thing to do. I think we have a deep obligation to get them to do this. The president has put out a sweeping package of reforms, strongest reforms we've contemplated as a country since the Great Depression, necessarily so because this was so damaging.
The House passed a bill very close to what the president proposed. Senator Dodd has put out a very good, strong bill. I do not think this is a Democratic or Republican thing. This is an American thing. I think you're going to see -- when this gets to the Senate floor, I think you're going to see a lot of support for this, because I think it's very hard for people in Washington to look their constituents in the eye and say, we've just had the worst financial crisis in generations, but we couldn't find the will as a country to reform the rules of the game.
While Maddow began her interview asking about financial reform, the most notable moments came when she told Geithner that she was "concerned" about the Fed and Geithner's former role at the agency. Maddow wondered why Geithner hesitated to press for reforms at financial institutions rescued by taxpayers during his tenure as chief of the New York Fed.MADDOW: That issue of how much authority you have, though, is where I get hung up, and why I'm still concerned about the Fed now, why I'm still concerned about you working at the Fed, frankly.
GEITHNER: Really, I'm happy -- you can go back over my record. I can tell you, with a lot of knowledge, of course, the stuff we were right on early, the stuff where we made a lot of difference early. But I can also tell you -- and I know a lot about this -- where the Fed was behind the curve and late. The best example of that was the Fed did not use its authority to write rules to provide better protection for consumers like in mortgages early. The chairman of the Fed has said that openly. I agree with that. That's why we proposed to take that authority away from the Fed, and give it to an agency where the people wake up every day, and they think about one thing, which is how to protect consumers.
Earlier in the interview, Maddow essentially asked Geithner "where were you?" during the crisis, and what he wished he had done differently in New York.
Geithner defended the agency saying that it "did a very good job" and acted early to "try to bring a bit of order to derivatives markets," though ultimately he acknowledged that the crisis was a tragic failure of government and that the New York Fed could have done more. He accepted limited personal responsibility, and spread the blame around the agency and the country, using the word "we" to respond to Maddow's question.
Last week, a bankruptcy examiner's report on Lehman Brothers revealed that the investment bank and financial-services firm was able to manipulate its balance sheet despite the fact that New York Fed regulators were stationed within the company. The New York Fed has also been criticized for ordering bailed-out insurer AIG to keep quiet about details of its taxpayer-funded payouts to the likes of Goldman Sachs ($14 billion+), Societe Generale ($16.5 billion), Deutsche Bank ($8.5 billion), and Merrill Lynch ($6.2 billion). Geithner led the agency through both events, though a spokesperson for the agency has said that Geithner "had no role or knowledge of the AIG disclosure matters."
WATCH: Part 1
WATCH: Part 2
Timmy-Gate: Did Geithner Help Hide Lehman Fraud?
by L. Randall Wray
Just when you thought that nothing could stink more than Timothy Geithner’s handling of the AIG bailout, a new report details how Geithner’s New York Fed allowed Lehman Brothers to use an accounting gimmick to hide debt. The report, which runs to 2200 pages, was released by Anton Valukas, the court-appointed examiner. It actually makes the AIG bailout look tame by comparison. It is now crystal clear why Geithner’s Treasury as well as Bernanke’s Fed refuse to allow any light to shine on the massive cover-up underway.
Recall that the New York Fed arranged for AIG to pay one hundred cents on the dollar on bad debts to its counterparties—benefiting Goldman Sachs and a handful of other favored Wall Street firms. The purported reason is that Geithner so feared any negative repercussions resulting from debt write-downs that he wanted Uncle Sam to make sure that Wall Street banks could not lose on bad bets. Now we find that Geithner’s NYFed supported Lehman’s efforts to conceal the extent of its problems. Not only did the NYFed fail to blow the whistle on flagrant accounting tricks, it also helped to hide Lehman’s illiquid assets on the Fed’s balance sheet to make its position look better. Note that the NY Fed had increased its supervision to the point that it was going over Lehman’s books daily; further, it continued to take trash off the books of Lehman right up to the bitter end, helping to perpetuate the fraud that was designed to maintain the pretense that Lehman was not massively insolvent.
Geithner told Congress that he has never been a regulator. That is a quite honest assessment of his job performance, although it is completely inaccurate as a description of his duties as President of the NYFed. Apparently, Geithner has never met an accounting gimmick that he does not like, if it appears to improve the reported finances of a Wall Street firm. We will leave to the side his own checkered past as a taxpayer, although one might question the wisdom of appointing someone who is apparently insufficiently skilled to file accurate tax returns to a position as our nation’s chief tax collector. What is far more troubling is that he now heads the Treasury—which means that he is not only responsible for managing two regulatory units (the FDIC and OCC), but also that he has got hold of the government’s purse strings. How many more billions or trillions will he commit to a futile effort to help Wall Street avoid its losses?
Geithner has denied that he played any direct role in the AIG bail-out—a somewhat implausible claim given that he was the President of the NYFed and given that this was a monumental and unprecedented action to funnel government funds to AIG’s counterparties. He may try to deny involvement in the Lehman deals. (Again, this is implausible. Lehman executives claimed they “gave full and complete financial information to government agencies”, and that the government never raised significant objections or directed that Lehman take any corrective action. In fairness, the SEC also overlooked any problems at Lehman. But here is what is so astounding about the gimmicks: Lehman used “Repo 105” to temporarily move liabilities off its balance sheet—essentially pretending to sell them although it promised to immediately buy them back. The abuse was so flagrant that no US law firm would sign off on the practice, fearing that creditors and stockholders would have grounds for lawsuits on the basis that this caused a “material misrepresentation” of Lehman’s financial statements. The court-appointed examiner hired to look into the failure of Lehman found “materially misleading” accounting and “actionable balance sheet manipulation.” (here) But just as Arthur Andersen had signed off on Enron’s scams, Ernst & Young found no problem with Lehman.
In short, this was an Enron-style, go directly to jail and do not pass go, sort of fraud. Lehman’s had been using this trick since 2001. It looked fine to Timmy’s Fed, which extended loans allowing Lehman to flip bad assets onto the Fed’s balance sheet to keep the fraud going.
More generally, this revelation drives home three related points. First, the scandal is on-going and it is huge. President Obama must hold Geithner accountable. He must determine what did Geithner know, and when did he know it. All internal documents and emails related to the AIG bailout and the attempt to keep Lehman afloat need to be released. Further, Obama must ask what has Geithner done to favor his clients on Wall Street? It now looks like even the Fed BOG, not just the NYFed, is involved in the cover-up. It is in the interest of the Obama administration to come clean. It is hard to believe that it does not already have sufficient cause to fire Geithner. In terms of dollar costs to the government, this is surely the biggest scandal in US history. It terms of sheer sleaze does it rank with Watergate? I suppose that depends on whether you believe that political hit lists and spying that had no real impact on the outcome of an election is as bad as a wholesale handing-over of government and the economy to Wall Street.
What did Timmy know, and when did he know it?
Point number two. Lehman used an innovation, “Repo 105” to hide debt. The whole Greek debt fiasco was caused by Goldman, et. al., who helped hide government debt. Whether legal or illegal, Wall Street has for many years been producing financial instruments designed to mislead shareholders, creditors, and regulators about the true financial position of its clients. Note that Lehman’s counterparties in this fraud included JP Morgan and Citigroup (who actually precipitated Lehman’s final failure when they finally called in their loans). It always takes at least three to tango: the firm that wants to hide debt, the counterparty that temporarily takes it off their books, and the accounting firm that provides the kiss of approval.
Worse, after aiding and abetting such deception, Goldman and other Wall Street institutions then place bets (using another nefarious innovation, credit default swaps) against their clients, wagering that they will not be able to service the debts—which are greater than the market believes them to be. Does that sound something like insider trading? How can regulators permit such actions?
What did Timmy know, and when did he know it?
Third point. To the extent that debt is hidden, financial institution balance sheets present an overly rosy picture—of course, that is the purpose of the financial “innovations”. Enron did it; AIG did it; Lehman did it. What about Bank of America, Citi, JP Morgan, Wells Fargo and Goldman? We now know that the New York Fed subjected Lehman to three wimpy “stress tests”, all of which it failed. Timmy’s Fed then allowed Lehman to construct its own sure-to-pass “stress” test. (We know, of course, that the test was absolutely meaningless because, well, Lehman passed the test and then immediately failed spectacularly. Timmy then let the biggest banks run their own stress tests, which they (surprise, surprise) managed to pass.
What did Timmy know, and when did he know it?
As our all-time favorite Fed Chairman Alan Greenspan liked to put it, “history shows” that when financial institutions pass their own stress tests, they are actually massively insolvent. There is no reason to believe that this time will be different. Mike Konczal reports that there is every reason to believe the biggest banks are hiding huge losses on second liens. These are second mortgages or home equity loans that amount to about $1 trillion of which almost half are held by the top four banks. Since the first principal of a mortgage is paid first, it is likely that much of the second liens are worthless. Yet banks are carrying these on their books at 86 to 87 percent of face value—which was necessary to allow them to pass the stress tests. Konczal shows that at a more reasonable loss rate of 40% to 60%, the four largest banks would have “an extra $150 billion hole in the balance sheet”. I won’t go into the policy conundrum implied for President Obama’s plan for principal reduction to help homeowners (the banks will not allow renegotiation of underwater mortgages because that would force them to recognize losses on the second liens).
Of greater importance is the recognition that all of the big banks are probably insolvent. Another financial crisis is nearly certain to hit in coming months—probably before summer. The belief that together Geithner and Bernanke have resolved the crisis and that they have put the economy on a path to recovery will be exposed as wishful thinking. In the bigger scheme of things, this is only 1931. We have a long way to go before bank assets (and nonbank debts) are written down sufficiently to allow a real recovery. In other words, a Minsky-Fisher debt deflation is still in the cards.
L. Randall Wray is a Professor of Economics at the University of Missouri-Kansas City who writes at New Economic Perspectives
Goldman Is to Greece What Merrill Was to Enron
by Simon Johnson
Did big banks break the law during our recent global debt-fuelled boom? The usual answer is: no - they just took advantage of loopholes and captured regulators. The world's biggest banks are widely supposed to be too sophisticated to be tripped up by the legal system.
But is this really true? The new Valukas report on Lehman suggests there are grounds for civil action, i.e., people can sue for damages. News reports give no indication of potential criminal charges, but this may change soon. The hiding of Lehman's true debt levels - through the so-called "Repo 105" structure - is strikingly reminiscent of how Enron's balance sheet was disguised through fake asset "sales" (as Senator Kaufman now points out).
And, of course, the people who ended up facing criminal charges and - in some prominent cases - going to jail, included not only Enron executives, but also responsible bankers from Merrill Lynch (see The Smartest Guys in the Room, Chapter 13). Arthur Anderson, Enron's accountant, was also effectively broken by the scandal. It is a serious crime for professional advisers and financiers to assist in securities fraud. The failure of Lehman therefore opens a can of worms for close and potentially productive examination in coming weeks. But so does the issue of Greek government debt in April 2002.
According to an offering circular dated 22 April 2002, The Hellenic Republic offered 3.5 billion of bonds, due 22 October 2022, that "will bear interest from, and including, 24 April 2002 at the rate of 5.90 per cent". The joint lead managers include, from the international side, Goldman Sachs, Morgan Stanley, and Deutsche Bank.
Goldman has, of course, admitted it helped manage down reported Greek debt levels through off-balance sheet transactions in 2000 and 2001. Gerald Corrigan, a senior Goldman executive, speaking before the UK Treasury Select Committee recently, said that the reduction in reported Greek debt was "small but significant"; in fact, it was around 1.6 percentage points of GDP, which is not small.
(From the Bloomberg story on Corrigan's testimony: "The transactions reduced the country's deficit by 0.14 percentage points and lowered its debt as a proportion of gross domestic product to 103.7 percent from 105.3 percent, according to Goldman Sachs." See also the less forthright Goldman Sachs statement on the company's website.)
The April 2002 offering circular did not disclose the debt swaps. There may have been other documentation available to investors that did reveal true Greek debt numbers - and perhaps these were discussed in the relevant road shows. We are not here taking a position on what was and was not disclosed; this is a matter for a proper official investigation. We also do not know what the other involved banks knew and when they knew it.
If it were the case that Greece's true debt levels were known and not disclosed by the investment bankers involved, any reasonable investor - or the sovereign debt experts with whom we have discussed this matter - would regard this as withholding adverse material information.
Gerald Corrigan, who is also former head of the New York Fed, argued that Goldman did "nothing inappropriate" - but he was referring to the off-balance transactions of 2000-2001. He has not yet spoken in public about the potential nondisclosure of material information in April 2002 (and perhaps at other dates after the Greece-Goldman swaps). As Senator Kaufman points out in his latest speech, there is nothing necessarily illegal about any non-disclosure in Europe - these bonds were issued under Greek law. And these bonds were definitely not registered under the US Securities Act of 1933; this is clear in the prospectus.
However, if any of these bonds were sold in the US to "qualified institutional buyers" (QIBs) under rule 144A (an exemption to registration requirements under the 1933 Securities Act), there is a potential legal issue (here I'm just rewording what Senator Kaufman said). Rule 10b-5, under the 1934 Securities Exchange Act, definitely applies to securities sold under 144A - i.e., selling securities to anyone in the United States while deliberately withholding material adverse information is not allowed.
Some people in the market think that around 10 percent of this Greek debt issue was sold under Rule 144A to QIBs; such sales may or may not have been handled by Goldman. Again, this can only be determined by an official investigation - hopefully the Senate Judiciary Committee, on which Senator Kaufman serves, can take this up. Goldman could be sued by investors who feel they were misled in this fashion - although, realistically, it would only happen if the bonds default; the cost of annoying Goldman otherwise is too high. Most likely Goldman will reach an amicable agreement with any aggrieved parties. (Merrill's problem was that Enron failed - as with Lehman, this launched an extensive set of enquiries).
Whether the SEC or any attorney general (e.g., in New York) will take any action, civil or criminal, remains to be seen. It is obviously hard - for legal and political reasons - to take on and prevail against one of the world's biggest and most powerful banks. Too big to fail banks are also too big to sue successfully - unless they collapse (which is why we keep coming back to Lehman). (Among other things, in the Greece case there would likely be a big argument about whether the Statute of Limitations applies and to whom.)
In any case, it is time to close the loophole that effectively allows deception regarding securities sold into the United States. Rule 144A should be abolished -- US residents (individuals and institutions) should only be allowed to buy securities that are properly registered with the SEC. If other countries are willing to have their people buy fraudulent securities, that is their problem. This is no longer acceptable in the United States.
Time for Truth: Three Card Monte is for Suckers
by Eliot Spitzer and William Black
In December, we argued the urgent need to make public A.I.G.’s emails and “key internal accounting documents and financial models.” A.I.G.’s schemes were at the center of the economic meltdown. Three months later, a year-long report by court-appointed bank examiner Anton Valukas makes it abundantly clear why such investigations are critical to the recovery of our financial system. Every time someone takes a serious look, a new scandal emerges.
The damning 2,200-page report, released last Friday, examines the reasons behind Lehman’s failure in September 2008. It reveals on and off balance-sheet accounting practices the firm’s managers used to deceive the public about Lehman’s true financial condition. Our investigations have shown for years that accounting is the “weapon of choice” for financial deception. Valukas’s findings reveal how Lehman used $50 billion in “repo” loans to fool investors into thinking that it was on sound financial footing. As our December co-author Frank Partnoy recently explained as part of a major report of the Roosevelt Institute, “Make Markets Be Markets“, such abusive off-balance accounting was and is endemic. It was a major cause of the financial crisis, and it will lead to future crises.
According to emails described in the report, CEO Richard Fuld and other senior Lehman executives were aware of the games being played and yet signed off on quarterly and annual reports. Lehman’s auditor Ernst & Young knew and kept quiet.
The Valukas report also exposes the dysfunctional relationship between the country’s main regulatory bodies and the systemically dangerous institutions (SDIs) they are supposed to be policing. The NY Fed, the regulatory agency led by then FRBNY President Geithner, has a clear statutory mission to promote the safety and soundness of the banking system and compliance with the law. Yet it stood by while Lehman deceived the public through a scheme that FRBNY officials likened to a “three card monte routine” (p. 1470). The report states:The FRBNY discounted the value of Lehman’s pool to account for these collateral transfers. However, the FRBNY did not request that Lehman exclude this collateral from its reported liquidity pool. In the words of one of the FRBNY’s on-site monitors: ‘how Lehman reports its liquidity is between Lehman, the SEC, and the world’” (p. 1472).
Translation: The FRBNY knew that Lehman was engaged in smoke and mirrors designed to overstate its liquidity and, therefore, was unwilling to lend as much money to Lehman. The FRBNY did not, however, inform the SEC, the public, or the OTS (which regulated an S&L that Lehman owned) of what should have been viewed by all as ongoing misrepresentations.
The Fed’s behavior made it clear that officials didn’t believe they needed to do more with this information. The FRBNY remained willing to lend to an institution with misleading accounting and neither remedied the accounting nor notified other regulators who may have had the opportunity to do so.
The Fed wanted to maintain a fiction that toxic mortgage products were simply misunderstood assets, so it allowed Lehman to maintain the false pretense of its accounting. We now know from Valukas and from former Treasury Secretary Paulson that the Treasury and the Fed knew that Lehman was massively overstating its on-book asset values: “According to Paulson, Lehman had liquidity problems and no hard assets against which to lend” (p. 1530). We know from Valukas’ interview of Geithner (p. 1502):The challenge for the government, and for troubled firms like Lehman, was to reduce risk exposure, and the act of reducing risk by selling assets could result in “collateral damage” by demonstrating weakness and exposing “air” in the marks.
Or, in plain English, the Fed didn’t want Lehman and other SDIs to sell their toxic assets because the sales prices would reveal that the values Lehman (and all the other SDIs) placed on their toxic assets (the “marks”) were inflated with worthless hot air. Lehman claimed its toxic assets were worth “par” (no losses) (p. 1159), but Citicorp called them “bottom of the barrel” and “junk” (p. 1218). JPMorgan concluded: “the emperor had no clothes” (p. 1140). The FRBNY acted shamefully in covering up Lehman’s inflated asset values and liquidity. It constructed three, progressively weaker, stress tests — Lehman failed even the weakest test. The FRBNY then allowed Lehman to administer its own stress test. Need we tell you the results?
We believe that the Valukas report cries out for an immediate Congressional investigation. As we did with A.I.G., we demand the release of the e-mails and internal documents from the New York Fed and Lehman executives that pertain to analyses of Lehman’s financial soundness. What downside can there possibly be in making these records available for public analysis and scrutiny?
Three years since the collapse of the secondary market in toxic mortgage product, we have yet to see significant prosecutions of the kind of fraud exposed in the Valukas report. The SDIs, with Bernanke’s open support, exorted the accounting standards board (FASB) to change the rules so that banks no longer need to recognize their losses. This has made the SDIs appear profitable and allows them to pay their executives massive, unearned bonuses based on fictional profits.
If we are to prevent another, potentially more devastating financial crisis, we must understand what happened and who knew what. Many SDIs are hiding debt and losses and presenting deceptive portraits of their soundness. We must stop the three card monte accounting practices that create the potential and reality of fundamental misrepresentation.
A.I.G.’s CEO, its board of directors, and the trustees that are supposed to represent the interests of the American people have failed to respond to our December letter calling on them to release to the public the AIG documents that would be the treasure trove (along with other SDI documents) that would allow our nation to uncover and end the gamesmanship that caused this financial crisis and will bring us recurrent crises. We call on them to act.
German bloc plays tough on Greece
by Ambrose Evans-Pritchard
German and allied northern states were still dragging their feet last night on a rescue for Greece, denying reports emanating from Brussels that the terms of a deal have been agreed. Officials played down hopes of a break-through at tomorrow's meeting of EU finance ministers, acknowledging German reluctance to be rushed into the creation of an EU fiscal union. Germany's finance minister, Wolfgang Schauble, denied that Berlin have signed off on a rescue, instead repeating his demand for tools to expel spendthrift states from the eurozone. "We need stricter rules: which means, in extremis, the means of ejecting a country from the euro area if it does not get its finances in order," he told Bild Zeiting.
His Dutch colleague, Jan Kees de Jager, said the EU was ready to help if it becomes necessary but added there would be "no free ride" and that any help would come at punitive rates to uphold market discipline. "There will be no bail-out, because a bail-out is forbidden by the EU Treaty," he said. The picture is muddied by the EU's policy of "constructive ambiguity", a strategy of conceding as little as possible in the hope that this will buy time for Greece to sort out its troubles. This has worked so far but markets may require concrete details before long.
The French press has talked of a €25bn (£22.7bn) plan, either through use of an EU bond, debt guarantees, or purchases of Greek debt by agencies such as Germany's KfW and France's Caisse des Deposits. But these are just options drawn up by experts. It is another matter to secure the backing of the German Bundestag and Germany's top court, which have questioned the legality of such actions.
Greece Avoids S&P Downgrade
Greece avoided a downgrade to its credit rating by Standard & Poor's Ratings Services, which had warned last month that it was considering such a move, although the ratings firm slapped on a negative outlook. The euro also rose in the minutes following S&P's announcement. S&P credit analyst Marko Mrsnik said the Greek government's plans to reduce its deficit was supportive of the nation's current triple-B-plus long-term credit rating, which is three notches into investment-grade territory. S&P said the government's reduction measures were "appropriate to achieve its 2010 fiscal target." However, the negative outlook, which means future downgrades are possible, reflected concern about Greece's ability to sustain the reform momentum.
"It indicates further downgrade potential if the government fails to address negative deviations from its budgetary consolidation path or implement the currently planned structural reforms," Mr. Mrsnik said. Earlier this month, the Greek parliament approved a third set of deficit-reduction measures to reinforce its budgetary consolidation strategy and meet its deficit target of 8.7% of gross domestic product in 2010. But despite the new measures, which affect both the revenue and expenditure side of the government's budget, S&P said it will be difficult for Greece to comply fully with its consolidation path in 2011 and 2012. Greece is struggling with a deficit that was expected to reach 12.7% of GDP last year, more than four times the ceiling set by European Union budget rules. Credit-rating firms have been pessimistic about Greece, which has a poor track record of debt management.
Tuesday, European Commissioner for Economic and Monetary Affairs Olli Rehn said Greece doesn't need financial help at the moment and that the European Commission thinks Greece is on track to make budget cuts worth 4% of GDP this year. Still, Greek government officials expressed frustration with borrowing costs that remain stubbornly high despite budget reforms and promises of aid from other countries in the 16-nation euro bloc. Greece would find it hard to cope with borrowing costs if they stayed at current levels, Finance Minister George Papaconstantinou said Tuesday, adding that he expects his country's borrowing costs to decrease as its plan to tackle budget problems gains credibility.
"It's clear that we are not happy to be paying the kind of mark-ups and spreads that we're paying at the moment," he said. "But as we have stated all along it's a question of rebuilding credibility and it's very clear now that this credibility is being rebuilt." Tuesday afternoon in Europe, Greece's benchmark 10-year bond yielded 6.25%, nearly double that of Germany, the euro zone benchmark, which stood at 3.15%. The finance minister's comments dashed expectations that Greece would launch another major bond issue as early as this week to help cover funding gaps over the next two months. "I don't think Greece will come out with a bond this week; perhaps next week," said Jens Peter Sorensen, chief analyst at Danske Markets in Copenhagen.
A Greek government official said last week that Greece needs the yield premium over Germany to shrink to around two percentage points before Greece must redeem some €22 billion of bonds in April and May. Mr. Papaconstantinou declined to be pinned down on plans for issuing debt. "I never make public pronouncements on dates, schedules, specific volumes of debt issuances," he told reporters. "The market is quite volatile, our spreads are quite volatile, so we take our decisions based on how we see the market." Greek Prime Minister George Papandreou, visiting in Budapest, said Greece shouldn't be forced to borrow at inflated rates of interest.
"We have said we are not asking for money, but we do need some form of instrument to intervene and make sure that we borrow at rates which are similar to the other countries' [rates] in the euro zone, which are not too expensive for Greece," he said. European Union finance ministers over the past two days have been discussing the technical aspects of a bailout plan that could be used to help Greece overcome its debt problems if required. Ministers said, however, that they haven't made any final decisions.
Those aspects include which countries would participate in the plan, its pricing structure and duration and what mechanisms would trigger its implementation, Mr. Papaconstantinou said. The points haven't been finalized, he said, "but I think based on [Monday's] decision and willingness of the Eurogroup to take this further, they will be made more explicit in [the] next few days." The Eurogroup consists of the finance ministers from the 16 countries that use the euro.
The proposed EU Greek bail-out cannot simply bypass German law
by Ambrose Evans-Pritchard
Does nobody read German any more? Nearly all the reports on Europe’s bail-out for Greece appear to be coming from Paris, or Madrid, or sources within the Brussels apparatus determined to seize on the EMU crisis to advance the “Project”, this time by leaps and bounds towards fiscal federalism. This cannot possibly be done without German backing, so it is academic what these people think or want. As of today, German finance minister Wolfgang Schauble has not yet agreed to anything beyond a last resort rescue “if insolvency were imminent” and if there were to be a threat to the “financial stability of the euro area as a whole”. That raises the bar very high.
He cannot go further because any bail-out for Greece would breach the EU’s no-bail-out-clause, and would therefore violate the German Grundgesetz, or constitutional law. Eurosceptics in Germany already have their fingers on the trigger, waiting to launch a court challenge if the line is crossed. Quite why markets/pundits seem to assume that the EU can just finesse this with its usual creativity — dare I say, its fundamental lawlessness — is beyond me. Germany is a serious country. The law matters. I can only conclude that the persistent refusal to treat this as a genuine problem is because these pundits do not read German newspapers. They can read French and hack Spanish or Italian, and normally that is enough in EU affairs, but sometimes it is not, and this occasion is one of them.
It reminds me of the massive misunderstanding that occurred before the ERM crisis 1992 when the British and others talked themselves into believing that the Bundesbank was going to relax monetary policy in order to rescue the system. Anybody reading, say, the Frankfurter Allgemeine’s excellent coverage of the Bundesbank knew that this could not possibly be true. Buba was more likely to raise rates to choke over-heating caused reunification with the East, and that is what happened, with calamitous results for a UK economy then at the other extreme of the economic cycle in a property slump.
Wolfgang Schauble, the German finance minister, has agreed to certain “technical modalities” but no sum has been specified, and no details have been offered, though the Dutch have talked of bilateral loans with a punitive rate of interest. You could call this yet more evidence of the EU’s policy of “constructive ambiguity”, or you could conclude that Berlin still refuses to be bounced into an EU debt union (and therefore into a unitary state) by countries in need. Instead, he repeated his demand for new treaty powers to expel recalcitrant debtors from the eurozone. He wants a European Monetary Fund, not to rescue countries in distress, but to beat them to a pulp if they refuse to comply with EU deficit rules. The Greeks know full well that the EU plan is still an empty shell, which is why government spokesman George Petilotis continues to mutter that his country will go to the IMF unless the EU comes up with something real by the end of the month.
As an aside, I happen to think that the German/EU policy of enforcing a ferocious fiscal squeeze on half Europe is demented and destructive. This Hooveresque strategy will tip these countries into a debt spiral, along the lines described by Irving Fisher in Debt Deflation Causes of Great Depressions (Economica, 1933). It will prove self-defeating, starting with Greece, which will see its public debt galloping up to 135pc of GDP this year. The policy will rebound against German exporters and Germany’s under-capitalized banks, ultimately dragging the entire eurozone into a deflationary swamp. Note that core inflation fell to a record low of 0.8pc in February. France’s Christine Lagarde is right to complain that Germany’s policy of perpetual wage-squeeze and export fetishism is untenable, and ultimately ruinous for monetary union.
I can think of no better way to destroy everything good that the EU has done in half a century. Yes, you might say — and North Europeans certainly will say — that Club Med states should not have wasted their windfall gains from EMU entry on credit bubbles. But how we got here is water under the bridge: what we do next determines whether Europe slides into social crisis. My own view is that the massive gulf in cost competitiveness that has emerged between Germany and the South was always implicit in the EMU system. Indeed, an army of German economics professors said as much in the 1990s. The politicians brushed aside warnings. Remember the quip by Edmund Stoiber: there will sooner be famine in Bavaria than an a bail out another EMU state as a result of the euro.
David Owen from Jefferies Fixed Income said there is no instance in modern history when a state has managed to pull off a fiscal squeeze equal to 4pc of GDP in the midst of a recession, as Greece is being told to do. (Though Latvia may qualify). “This is monumental tightening: it’s ludicrous. What concerns me is how the markets will react once it becomes clear later this year that Greece’s deficit is not going down by much, if at all.” Be that as it may, the immediate political issue is that whatever Berlin wants to do over Greece, its hands are tied by the Verfassungsgericht, or constitutional court. This is the same court that issued a thundering ruling on the Lisbon Treaty last year, reminding EU Putchists that sovereign states are “Masters of the Treaties” and not the other way round, and that national parliaments are the only legitimate fora of democracy.
The general tone of the ruling resonates with scepticism vis-à-vis the integration process. The Court constructs a line of defence against any possible infringements of German sovereignty, stating that certain fields “must forever remain under German control.” One of those is fiscal policy. EU lawyers like to ignore this ruling, or feign to ignore it. German politicians cannot and will not trifle with their sovereign court. So if you think Germany has just signed up to blanket bail-out for Greece, let alone Club Med, think again.
Junk Bond Avalanche Looms for Credit Markets
When the Mayans envisioned the world coming to an end in 2012 — at least in the Hollywood telling — they didn’t count junk bonds among the perils that would lead to worldwide disaster. Maybe they should have, because 2012 also is the beginning of a three-year period in which more than $700 billion in risky, high-yield corporate debt begins to come due, an extraordinary surge that some analysts fear could overload the debt markets.
With huge bills about to hit corporations and the federal government around the same time, the worry is that some companies will have trouble getting new loans, spurring defaults and a wave of bankruptcies. The United States government alone will need to borrow nearly $2 trillion in 2012, to bridge the projected budget deficit for that year and to refinance existing debt. Indeed, worries about the growth of national, or sovereign, debt prompted Moody’s Investors Service to warn on Monday that the United States and other Western nations were moving “substantially” closer to losing their top-notch Aaa credit ratings.
Sovereign debt aside, the approaching scramble for corporate financing could strain the broader economy as jobs are cut, consumer spending is scaled back and credit is tightened for both consumers and businesses. The apocalyptic talk is not limited to perpetual bears and the rest of the doom-and-gloom crowd. Even Moody’s, which is known for its sober public statements, is sounding the alarm. “An avalanche is brewing in 2012 and beyond if companies don’t get out in front of this,” said Kevin Cassidy, a senior credit officer at Moody’s.
Private equity firms and many nonfinancial companies were able to borrow on easy terms until the credit crisis hit in 2007, but not until 2012 does the long-delayed reckoning begin for a series of leveraged buyouts and other deals that preceded the crisis. That is because the record number of bonds and loans that were issued to finance those transactions typically come due in five to seven years, said Diane Vazza, head of global fixed-income research at Standard & Poor’s.
In addition, she said, many companies whose debt matured in 2009 and 2010 have been able to extend their loans, but the extra breathing room is only adding to the bill for 2012 and after. The result is a potential financial doomsday, or what bond analysts call a maturity wall. From $21 billion due this year, junk bonds are set to mature at a rate of $155 billion in 2012, $212 billion in 2013 and $338 billion in 2014. The credit markets have gradually returned to normal since the financial crisis, particularly in recent months, making more loans available to companies and signaling confidence in the pace of economic recovery. But the issue is whether they can absorb the coming surge in demand for credit.
As was the case with the collapse of the subprime mortgage market three years ago, derivatives played a big role in the explosion of risky corporate debt. In this case the culprit was a financial instrument called a collateralized loan obligation, which helped issuers repackage corporate loans much as subprime mortgages were sliced, diced and then resold to other investors. That made many more risky loans available. “The question is, ‘Should these deals have ever been financed in the first place?’ ” asked Anders J. Maxwell, a corporate restructuring specialist at Peter J. Solomon Company in New York.
The period from 2012 to 2014 represents payback time for a Who’s Who of private equity firms and the now highly leveraged companies they helped buy in the precrisis boom years. The biggest include the hospital owner HCA, which was taken private in 2006 by a group led by Bain Capital and Kohlberg Kravis & Roberts for $33 billion, and has $13.3 billion in debt payments coming due between 2012 and 2014. Another buyout led by Kohlberg Kravis, for the giant Texas utility TXU, has $20.9 billion that needs to be refinanced in the same period.
Realogy, which owns real estate franchises like Century 21 and Coldwell Banker, was taken private by Apollo in the spring of 2007 just as the housing market was beginning to unravel and as the first tremors of the subprime crisis were being felt. Realogy was saddled with $8 to $9 of debt for every $1 in earnings, well above the “$5 to $6 level that is manageable for a company in a highly cyclical industry,” according to Emile Courtney, a credit analyst with Standard & Poor’s. Realogy has survived — barely. “The company’s cash flow is still below what’s needed to cover the interest on its debt,” Mr. Courtney said.
Realogy said it ended 2009 with a substantial cushion on its financial covenants and over $200 million of available cash on its balance sheet. “The company generated over $340 million of net cash provided by operating activities in 2009 after paying interest on its debt,” the company said. Not everyone is convinced that 2012 will spell catastrophe for the junk bond market, however. Optimists like Martin Fridson, a veteran high-yield strategist, note that investors seeking high yields snapped up speculative-grade bonds last year and early this year, and he suggests that continued demand will allow companies to refinance before their loans come due. “The companies have nearly two years to push out the 2012 maturity wall,” he said. “Of course, the ability to refinance will depend upon the state of the economy.”
That is still a wild card, but even if the economy improves, companies with a lot of debt will be competing with a raft of better-rated borrowers that are expected to seek buyers of their debt at around the same time. Chief among those is the best-rated borrower of all: the United States government. The Treasury Department estimates that the federal budget deficit in 2012 will total $974 billion, down from this year’s $1.8 trillion, but still huge by historical standards. Most critics of deficit spending have focused on the budget gap alone, but Washington will actually have to borrow $1.8 trillion in 2012, because $859 billion in old bonds will come due and have to be refinanced in addition to the deficit. By 2013 and 2014, $1.4 trillion will have to be raised annually.
In the late 1990s, the federal government ran a surplus and actually paid down a small portion of the national debt. But with the huge deficits of the last few years, the national debt has grown to more than $12 trillion. Next in line are companies with investment-grade credit ratings. They must refinance $1.2 trillion in loans between 2012 and 2014, including $526 billion in 2012. Finally, there is the looming rollover of commercial mortgage-backed securities, which will double in the next three years, hitting $59.7 billion in 2012. Even if most of the debt does get refinanced, companies may have to pay more, if heavy government borrowing causes rates for all borrowers to rise.
“These are huge numbers,” said Tom Atteberry, who manages $5.6 billion in bonds for First Pacific Advisors, and is particularly alarmed by Washington’s borrowing. “Other players will get crowded out or have to pay significantly more, because the government is borrowing so much.”
Congress letter urges action on renminbi
More than 100 members of the US Congress on Monday called on the Obama administration to label China a currency manipulator, in a move that highlighted the pressure on Washington to take a more confrontational stance towards Beijing. In a letter to Timothy Geithner, Treasury secretary, and Gary Locke, commerce secretary, the 130 Congressmen demanded the administration designate China a manipulator when it issues its regular report on currency manipulation next month. They called for countervailing duties to be imposed on Chinese imports. “I have not really seen this level of enthusiasm among members of Congress before,” said Tim Ryan, one of the Congressmen organising the bipartisan letter. “There is a heck of a coalition behind this and the time is right.”
The letter adds to pressure on the Obama administration, which is trying carefully to manage its relationship with China, one of the largest buyers of US government debt, amid fears a rift could unnerve investors and undermine recovery. The Obama administration has been reluctant to designate China a currency manipulator at a time when figures including Mr Geithner have sought to work with Beijing. The US has looked for support from China on a range of issues from climate change to United Nations sanctions on Iran. But, with US unemployment at nearly 10 per cent, the administration has also identified the alleged overvaluation of the renminbi as a top priority. Calls from the Democratic party’s base for a tougher line have intensified.
“It’s politically important for Democrats obviously but there are also many Republicans and small business owners that would benefit from this,” said Mr Ryan, who hailed Mr Obama for having taken “a more aggressive approach on enforcing our trade agreements than any president has for 30 years”. The letter adds that, after a formal designation, the US should begin talks with China on its foreign exchange regime and signal its willingness to enter a formal complaint at the World Trade Organisation. “This is very risky. On both the Chinese and the US sides the leadership feels that you have to keep the relationship on an even keel, but with domestic feelings running high there is a risk that it gets out of control,” said Eswar Prasad, an expert at Cornell University and the Brookings Institution.
“There is a consensus building in the US that China’s position on the currency is untenable and that China is throwing its weight around in a way that is unfriendly,” he added. ”The perception in China is that the dynamic in the bilateral relationship has shifted completely to Beijing’s advantage.” In a letter last month 15 US Senators criticised Mr Locke for having “failed” to adequately investigate charges that China deliberately undervalued its currency for trade advantages while a number of members of Congress have introduced legislation to label Beijing a manipulator.
The US Treasury declined to comment on the latest call. The last time it designated a country as having manipulated its currency was in 1994, when it identified China as having done so. Since then trade between the two countries has risen enormously, with Chinese exports to the US reaching $296bn in 2009 and imports hitting $70bn. Mr Prasad adds that China holds about 10 per cent of the total US outstanding government debt of $7,800bn.
U.K. Probes Accounting at Lehman
The U.K.'s Financial Reporting Council, the regulator for accounting and auditing, said Monday it had started looking at how Lehman Brothers Holdings Inc. repo transactions were accounted for and audited in the U.K. It said it was seeking extra information from Lehman's former auditor, Ernst & Young. The move follows a report by the bankruptcy examiner for Lehman last week that said there may be sufficient evidence to support claims of negligence and malpractice against Ernst & Young over the repo transactions, which allowed Lehman to move $50 billion off its books and make it appear stronger than it was. The FRC said it wanted to "ascertain the facts" and it wanted to "determine any implications."
"At this stage, we are just establishing whether any U.K.-based companies or individuals are implicated in the report," an FRC spokesman said. Both Lehman and Ernst & Young have U.K. subsidiaries, and the report also refers to a U.K. legal opinion from London-based law firm Linklaters, he added. Ernst & Young said it was cooperating "with all relevant parties on this matter." The FRC is responsible for licensing auditors within the U.K. and can refer any individuals or companies to the accounting discipline board. The spokesman said it was also dealing with the U.K.'s main financial regulator, the Financial Services Authority.
The U.S. probe and report on Lehman disclosed a lack of information and a number of confusing and sometimes contradictory agreements between Lehman and its lenders in the repo market. The repo market involves firms raising cash to fund operations by posting high-quality assets as collateral with other financial institutions, with an obligation to repurchase them within days. This short-term lending was the lifeblood of Wall Street, but the U.S. report suggests much of the collateral used by Lehman was illiquid and in some cases worth practically nothing.
In its report last week, the U.S. bankruptcy examiner said there may be sufficient evidence to support claims of negligence and malpractice against Ernst & Young, as Lehman's auditor, for its audits on the company and its failure to act upon claims from a whistle blower that Lehman's accounting for a trade known as "Repo 105" was misleading. Meanwhile, Phil Angelides, the head of a commission set up by Congress to examine the causes of the financial crisis, said Monday that investigators are probing how pervasive the accounting maneuvers that destroyed Lehman are on Wall Street.
EU calls for faster UK deficit cuts
The government's plans for reducing the budget deficit are not ambitious enough - according to a European Commission report to be published on Wednesday. The report warns that the UK is not on course to cut its deficit in line with EU rules by a deadline of 2015. Chief Secretary to the Treasury Liam Byrne said the report was "wrong" and would mean £20bn more in spending cuts. Ministers insist their plans to halve the deficit in four years are less likely to halt the economic recovery.
In an interview with the BBC, Mr Byrne said the spending cuts and tax rises required to meet the EU target would cause "irreparable damage" to the economy. Shadow business secretary Ken Clarke, also speaking to the BBC, said the EU was right and the government needed to cut spending more rapidly, which could be done easily. He said the UK needed to cut its deficit or "interest rates will rise, unemployment will rise and there will be no economic recovery".
Liberal Democrat Treasury spokesman Vince Cable said the European Commission report was a blow to the government and its handling of the economy. "Gordon Brown has set great store by leadership of the international community on the economic crisis, so when leading institutions in the international community start criticising the way he is going about economic management then that is humiliating, frankly," he added. EU rules say government deficits must be below 3% of GDP, but the UK's deficit is expected to hit £178bn - or 12.6% of GDP - this year. Labour's plans, announced in the pre-Budget report, would see the UK's deficit reduced to 4.7% by 2015 - missing the EU target outlined by finance ministers last year.
In the run-up to next week's Budget, Chancellor Alistair Darling has defended the government's approach to the deficit, arguing that cutting it too quickly by reducing government spending would risk harming the UK's emergence from recession. "The chancellor's judgement on the pace of this adjustment takes into account the need to support the economy through the early stages of the recovery," a Treasury spokesman said. "To withdraw support earlier and at the wrong pace risks wrecking the recovery - a judgement supported by the Commission."
The Treasury said the government's plan was the sharpest and fastest deficit reduction proposal in the G7 leading industrial nations. But the Liberal Democrats said that to be credible, parties needed to show what they would cut. A draft of the Commission's report suggests that "additional fiscal tightening measures" beyond those already planned are needed if the health of public finances is to be restored "within a credible timeframe". The report also calls into question the Treasury's forecasts for the UK's economic growth.
Its forecast of 2% growth in 2010-11, and then 3.3% growth for the next four years could prove optimistic, the Commission argues, should the global economy fail to recover as strongly as expected. "The message from the Commission will be that the UK needs to get its house in order," an EU official said. The shadow chancellor, George Osborne, said a change of government was needed to restore confidence in the UK economy. He added: "The Conservatives have been arguing that we need to reduce our record budget deficit more quickly in order to support the recovery."
BBC political correspondent Ross Hawkins said the European Commission had walked "slap bang into the middle of an enormous political row". He said the issue of whether to cut "sooner or deeper" would play "at the heart" of the forthcoming election as each parties' plans were scrutinised. "All the competing parties say they've got the answer and their opponents are misreading the situation," he said. The timing meant the topic had far greater impact than it would otherwise, he added.
Wall Street Dominance of Swaps Must End, Brokers Say
MF Global Holdings Ltd., Jefferies Group Inc. and at least 19 financial firms want regulators to force swaps clearinghouses to lower entry barriers that restrict competition in a $605 trillion derivatives market dominated by the world’s biggest banks. Brokers formed an association last month that hired a Washington-based law firm to pursue the issue with lawmakers and regulators, said Mike Hisler, a partner at New York-based Hexagon Securities LLC, a member of the group. They also seek tougher rules to ensure banks trading derivatives don’t try to sway clearinghouse decisions to shut out new competitors.
The debate about access takes place as Congress seeks to empower regulators to dismantle failing financial firms deemed to pose a systemic threat to the economy. Limiting the number and types of firms that can join derivatives clearinghouses concentrates too much risk there, the excluded firms say. It also blocks competition for the largest U.S. banks that made an estimated $28 billion trading derivatives last year.
“If we can have more members or participants it would be a good thing” for the stability of the clearinghouses and the market, said Patrice Blanc, chief executive officer of Newedge USA LLC, the world’s largest futures broker, which is aware of the regulatory lobbying though not a member of the group. “The banks don’t want to open the model; they’re making too much money.”
The clearing restrictions pit small to mid-size brokers and broker-dealers against their larger competitors, including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Deutsche Bank AG. Goldman spokesman Michael DuVally, Deutsche Bank spokeswoman Michele Allison and JPMorgan spokesman Justin Perras declined to comment. Only firms with a net worth of at least $5 billion are allowed to be members of the largest credit-default swap clearinghouse, Intercontinental Exchange Inc.’s ICE Trust. At CME Group Inc.’s venture, that requirement is $500 million, recently raised from $300 million. Both demand expertise in the market, including swaps-trading desks.
Adding more clearinghouse members for swap trades “is in the best interest of the entire financial system,” said Hexagon’s Hisler, whose firm is one of about 20 members of the newly formed Swaps and Derivatives Market Association, which hired law firm Venable LLP to represent them. “Counterparty diversification, like portfolio diversification, is always a wise strategy.” Miller Tabak Roberts Securities LLC, BTIG LLC and StormHarbour Partners LP also belong to the association, executives and spokespeople from the firms said.
“We’re working with regulators and exchanges to impress upon them the importance of diverse models” of how brokers and banks can gain access to clearinghouses, said Bernard Dan, chief executive officer of MF Global, which isn’t a member of the group. The broker is building its capabilities and hiring traders in the credit-swaps market so that “maybe in six to eight months we’ll be seen as a major execution agency player,” he said. MF Global, Newedge and other firms want to act only as brokers and not as market makers, which buy and sell swaps for their own accounts. To gain access to swaps clearinghouses, brokers have to hand over the trades to JPMorgan or another member for processing, limiting how much they can afford to charge customers.
JPMorgan, Bank of America Corp., Goldman Sachs, Morgan Stanley and Citigroup Inc. executed 96 percent of the $293 trillion in over-the-counter derivatives trades made by the top 25 U.S. bank-holding companies and their customers as of Sept. 30, according to the Office of the Comptroller of the Currency. Newedge said it’s being shut out of LCH.Clearnet Ltd., the world’s largest interest-rate swap clearinghouse, because of requirements that it have a net worth of $5 billion and at least $1 trillion in outstanding swaps business. “It’s difficult for us to enter this market,” Newedge’s Blanc said. Newedge doesn’t want a mandated solution imposed by regulators, said Gary DeWaal, the firm’s general counsel. Instead, it wants access to clearinghouses and believes the market will reward the operation that is most open to as many users as possible, he said.
At stake is access to the privately negotiated derivatives markets that generated an estimated $28 billion in revenue last year for the five biggest U.S. dealers, according to company reports collected by the Federal Reserve and people familiar with banks’ income sources. The Swaps and Derivatives Market Association is asking Congress to give regulators, not clearinghouses, the power to set capital requirements and other rules for membership, according to a mission statement obtained by Bloomberg News. The group also wants tougher conflict-of-interest rules that would require firms to maintain a wall preventing information exchange between their trading desks and clearing operations.
Roger Liddell, chief executive officer of LHC.Clearnet, said the entry barriers are needed because companies making a market in swaps take great risk and must be able to help unwind positions of a bankrupt member bank. “Being a direct member may bring certain privileges, but it also brings significant responsibilities,” Liddell said. “It’s all based on their ability to be able to step in and help us with a default. Some of the firms that want to become direct members don’t have the ability to do that.”
Clearinghouses are capitalized by their members in a structure meant to ensure that trading parties are made whole if any member defaults. They collect margins on outstanding trades each day to keep accounts current and give regulators access to information on market positions. “The ability to understand the risk profile” of the credit-default swap market by trading as a dealer, not just brokering transactions, is vital for members, said Kim Taylor, president of CME Group’s credit-swaps clearinghouse. Each day its market-maker members provide prices for where contracts are sold and bought to set its margins.
Intercontinental’s clearinghouses have backed $6.3 trillion of credit-swaps trades between banks, according to its Web site. CME has guaranteed $189.5 million. In December, both clearinghouses started allowing banks to clear trades with clients. “It’s very early days in OTC clearing,” said Kelly Loeffler, a spokeswoman for Intercontinental. “We’re moving quickly to bring as much business into a cleared environment under the existing regulatory structure,” she said.
Many members of the Swaps and Derivatives Market Association, like Hexagon, hired former Wall Street traders or salespeople familiar with pitching derivatives trades to hedge funds, insurance companies and other money managers, said Hisler, who joined Hexagon in January 2009 from UBS AG, where he ran a sales group that transacted in corporate bonds, credit- default swaps and collateralized debt obligations among other securities. “We are not asking for market share; we are asking for the ability to compete for market share,” Hisler said.
We need explicit rules for bail-outs
by Lorenzo Bini Smaghi
One of the many lessons we can draw from the financial crisis – and one supported by the literature on behavioural economics – is that economic agents do not always behave rationally, especially when they take decisions affecting others. Research has shown in particular that agents are not only motivated by self-interest, as economists are keen to believe, but also by considerations of fairness. Various studies have demonstrated that under certain circumstances individuals may even be prepared to renounce additional income if they believe this achieves a more equitable distribution of wealth within the community. For instance, experiments have been conducted, in particular at the universities of Oxford and Warwick, in which participants could pay for the opportunity to “burn” money belonging to other members of the group. Most chose to do so and targeted the richest participants.
This behaviour is not unlike the many negative reactions recently to the prospect of taxpayers’ money being used to bail out the banking system, even though a systemic failure would have represented an even greater financial loss for taxpayers and society as a whole. It might well explain also the opposition in some countries to providing assistance to other, financially distressed countries, even though the distress of the latter might ultimately spread to the former.
Such attitudes make it difficult for governments to act consistently in times of crisis, especially when elections are close. This was notably the case in September 2008, shortly before the US presidential election, when Congress, despite the gravity of the situation, rejected the government’s bail-out plan until Lehman Brothers’ failure made it apparent that the risk of financial collapse would have devastating effects for all.
In short, if people react irrationally, at least in the short term, democracies may find it very difficult to tackle crises that demand swift decisions. Systems and institutions with specific crisis-resolution mandates thus need to be established to permit rapid responses, while at the same time maintaining democratic legitimacy.
The traditional counterargument to this view is that it increases moral hazard. If the way out of a crisis, including any hint of financial support, is indicated too clearly, economic agents or even countries may be inclined to be less financially disciplined, in the expectation that they will ultimately be bailed out. “Constructive ambiguity” is the approach needed to ensure that agents take appropriate action to avert a crisis. They are more likely to follow such a path if they cannot be certain of receiving financial assistance should their problems escalate.
However, constructive ambiguity also means that, if and when needed, assistance is provided as a last resort to ensure that corrective measures are taken and contagion is avoided. If the authorities responsible for taking the decision to grant assistance are in the end not able to deliver, the whole concept of constructive ambiguity collapses. The impact on the financial markets might lead to greater instability as opportunities for destabilising speculative strategies increase.
The developments of the past few months related to market assessments of the solvency of financial institutions, or even of sovereign countries, suggest that the issue of moral hazard cannot be tackled simply by assuming that crises will not occur. Nor can it be assumed that letting an institution or a country fail is always and everywhere the most desirable solution, as the post-Lehman experience has shown. Decision-makers in both the public and private sectors must thus be ready to deal with worst-case scenarios and make sure that they are not prevented from delivering the appropriate decisions. Moral hazard should then be addressed by establishing institutions and procedures that allow for incentive-compatible solutions (carrots as well as sticks).
This means, in particular, that financial assistance, if needed to avert a major systemic crisis, can be granted on strict conditions that aim to prevent any recurrence of the problem. It also entails harmonised insurance mechanisms and resolution regimes that do not create distortions between countries, especially within the European Union. In the light of recent developments, policymakers should not assume that they have plenty of time to address these issues.
Lorenzo Bini Smaghi is a member of the executive board of the European Central Bank
Deutsche Bank, JPMorgan, UBS Are Charged With Derivatives Fraud
Deutsche Bank AG, JPMorgan Chase & Co., UBS AG and Hypo Real Estate Holding AG’s Depfa Bank Plc unit were charged with fraud linked to the sale of derivatives to the City of Milan. Judge Simone Luerti scheduled the trial of the four firms, 11 bankers and two former city officials for May 6, Prosecutor Alfredo Robledo said after a hearing in Milan today. The banks allegedly misled the city on swaps that adjusted interest payments on 1.7 billion euros ($2.3 billion) of borrowings.
Prosecutors across Italy are probing banks as local and national government agencies face potential losses of 2.5 billion euros on derivatives, lawyers say. The Milan probe may also affect cases as far away as the U.S., where securities firms have faced charges for price-fixing and bid-rigging in the sale of derivatives to municipalities, though not for fraud, according to former regulator Christopher “Kit” Taylor. “This case could have repercussions over here if the trial showed deliberate intent,” said Taylor, a former executive director of the Municipal Securities Rulemaking Board, the national regulator of the municipal-bond market. “What happened in Europe was the continuation of a pattern in the U.S.”
Robledo alleges the London units of the four banks misled Milan on the economic advantage of a financing package that included the swaps and earned 101 million euros in hidden fees. He also claims the banks violated U.K. securities rules by failing to inform Milan in writing that for the swap deal the city was a counterparty to the lenders rather than a customer. Banks abiding by the rules of the Financial Services Authority are required to shield customers from conflicts of interest and provide them with clear and fair information that isn’t misleading.
The prosecutor, who seized assets from the banks equal to their share of the alleged profit, is claiming JPMorgan charged about 45 million euros in commissions that were hidden from the municipality, while Deutsche Bank made about 25 million euros, Depfa Bank earned 21 million euros and UBS made 10 million euros, court documents show. “The thesis brought forward by the prosecutor was particularly innovative and aggressive,” said Giampiero Biancolella, an attorney specializing in financial crime who isn’t involved in the case. “The indictments prove the allegations are legitimate, though the charges don’t yet prove the banks are guilty.”
In another Italian investigation, magistrates in the region of Apulia are probing Bank of America Corp. and last month requested the company be stopped from doing business with the country’s municipalities for two years amid allegations it misled the municipality on derivatives linked to 870 million euros of bonds. A unit of Dexia SA is also under investigation in the same case. Separately, Nomura Holdings Inc. bankers are under investigation for alleged fraud relating to derivatives contracts sold to the Italian region of Liguria in 2004, people familiar with the case said last month. Derivatives are unregulated financial instruments linked to stocks, bonds, loans, currencies and commodities, or related to specific events such as changes in interest rates or the weather.
The allegations have prompted Italian lawmakers to propose new rules restricting the use of derivatives among municipalities by boosting oversight and banning upfront payments. Italy’s Senate Finance Committee on March 11 unanimously approved a proposal on tighter rules that will be used by the finance ministry to shape regulation. Through swaps, “banks found a way to sell something that is debt without making it look like debt,” said Taylor, who advises a law firm that has sued banks on behalf of residents of Jefferson County, Alabama, which was on the brink of bankruptcy after swaps backfired.
Bank Chief Accused of TARP Fraud
A lifelong banking-industry executive was arrested Monday on numerous charges, including allegations of defrauding regulators in connection with what prosecutors said was his desperate effort to save his New York bank from failing. Charles J. Antonucci Sr., the former president and chief executive of the Park Avenue Bank of New York, made false statements to regulators in an effort to obtain about $11 million from the U.S. government's Troubled Asset Relief Program, prosecutors said. He is the first person to be charged criminally with attempting to defraud TARP, the bank bailout program passed as the nation teetered on the verge of an economic meltdown in 2008, prosecutors said.
Park Avenue Bank, a lender with more than $500 million in assets that specialized in commercial-real-estate loans, failed on Friday after piling up more than $27 million in net losses last year. Bad real-estate loans shrank the bank's capital to just $3.3 million at year's end, down 87% from two years earlier, according to filings the bank made with the Federal Deposit Insurance Corp. "The bank was broken, so, in October and November 2008, [Mr.] Antonucci methodically went about pretending to fix it," said Preet Bharara, the U.S. attorney in Manhattan, at a press conference.
Prosecutors charged Mr. Antonucci with 10 counts of fraud, bribery and other crimes, including accepting free plane rides from a bank customer and stealing $103,000 from pastors of a church in Coral Springs, Fla. He could face up to 30 years in prison for each fraud and embezzlement charge. The bank's four branches were taken over by Valley National Bank. Mr. Antonucci was taken into custody by federal agents at 7 a.m. at his home in Fishkill, N.Y. Unshaven and bespectacled, he sat quietly next to his lawyer and said little at a bail hearing Monday. He wore a red St. John's University hooded sweatshirt, blue track pants and brown loafers.
Bail was set at $2 million, to be secured by his home in Fishkill and his wife's apartment in Queens, N.Y. "These charges are what they are," said Charles Stillman, a lawyer for Mr. Antonucci. "We're going to study them and consider what our appropriate response to the charges will be." The criminal charges against Mr. Antonucci come as regulators are ratcheting up their efforts to hold bank executives responsible as more financial institutions succumb to bad real-estate loans and other problems. In January, a former executive at Omni National Bank, a failed bank in Atlanta, pleaded guilty to charges he overvalued bank assets in a bid to hide mortgage fraud. The former executive, Jeffrey Levine, is scheduled to appear before United States District Judge Jack Camp on March 23 for sentencing in his case.
The lending practices at Integrity Bank, an Alpharetta, Ga., lender seized by banking regulators in 2008, are under investigation by the FDIC. Lawyers for bank executives have declined to comment. Mr. Antonucci held numerous positions in the banking industry before organizing a group of investors in 2004 to invest more than $10 million in Park Avenue for about 85% of the common stock, according to a person familiar with the matter. The bank, named after its location on Park Avenue, was struggling at the time, and Mr. Antonucci touted to investors his experience at working with regulators and turning around troubled banks, the person said.
The lead investor was real-estate developer David Lichtenstein, best known for his ill-fated acquisition of the Extended Stay Hotels chain, which is operating under bankruptcy protection. Mr. Lichtenstein hasn't been accused of wrongdoing. Under Mr. Antonucci, the bank increased assets to $500 million from $100 million at the end of 2004, making loans throughout the region to commercial-real-estate owners, and to a racetrack in the Catskill Mountains. But like many other small banks across the country, Park Avenue saw its soured loans jump after the financial crisis hit in 2007.
According to Foresight Analytics, a banking research firm in Oakland, Calif., delinquencies on commercial property loans held by the bank jumped to 23% at year's end, up from about 18% a year earlier and 7.7% at the end of 2007. In September 2008, the FDIC declared that the bank was "undercapitalized." This growing stress led to one of the schemes alleged in the criminal compliant. In the fall of 2008, Mr. Antonucci announced he had shored up the bank's capital base by investing $6.5 million of his own money, according to the complaint. But, in fact, the money came from the bank. Mr. Antonucci had set up a series of fraudulent transactions to make it seem like it was coming from him, the complaint states.
The federal investigation of Mr. Antonucci began about five months ago, when the Ecuador office of the Department of Homeland Security's U.S. Immigration and Customs Enforcement learned of a person interested in engaging in an illegal business deal with Mr. Antonucci, according to James Hayes, the agent in charge of ICE's New York office. He declined to elaborate. The complaint also alleges Mr. Antonucci used a bank-consulting firm he owns to funnel Park Avenue Bank's money to himself. In addition, according to the bank bribery section of the indictment, he received free flights on more than 10 occasions in 2008 and 2009 on the private plane of a bank customer, including to the Super Bowl, Panama and the Masters golf tournament in Augusta, Ga.
Federal prosecutors alleged Mr. Antonucci arranged for Park Avenue to lease space from three properties he owned, causing the bank to spend more than $1 million to improve, lease and pay expenses on the properties, the complaint says. The bank used only one of the properties, according to the complaint. Mr. Antonucci also was accused of stealing more than $103,000 from pastors of a church in Coral Springs, Fla., by offering to pay four times their investment through a purported bond, according to the complaint. The money was deposited in an account he controlled at the bank and never repaid, according to prosecutors. Instead, Mr. Antonucci divided the money with an unnamed co-conspirator, according to the complaint. Park Avenue Bank of New York isn't affiliated with Park Avenue Bank in Georgia.
Ilargi: Shell’s figured a new way to boost profits: sell your assets. That should work. For a day or two.
Shell to sell refineries to boost output
Royal Dutch Shell has unveiled the most dramatic overhaul of its business in recent memory, outlining plans to exit more than a third of its 90 retail markets, slash refining capacity and return to growth after seven years of falling output. Peter Voser, chief executive, unveiled a further 1,000 jobs cuts in addition to the 6,000 already announced as he vowed to "sharpen up" Shell in the next three years by boosting output by 11pc. "Shell has been disadvantaged recently, due to our higher exposure to refining and natural gas, where margins are hard-wired to the economy," Mr Voser said.
"The priorities are for a more competitive performance, for growth, and for sharper delivery of strategy. We have more to do to drive out cost and improve the operating performance in the company." Shell plans to exit 35pc of its petrol station markets and reduce refining capacity by 15pc to help it make cost saving of $1bn (£658m) this year. It also said it would sell non-core assets worth $1bn-$3bn a year, including its refineries in Gothenburg, Los Angeles and New Zealand.
Monday is the deadline for bids for the company's liquified petroleum gas distribution arm, which could raise £1.1bn. Those understood to be tabling offers include Brazilian chemicals group Ultrapar, Centrica spin-off DCC and French listed Rubis, as well as a number of private equity groups. "Upstream, we have built up strong foundations in activities like gas-to-liquids, oil sands and liquefied natural gas," Mr Voser said. "Looking out to 2020, I expect Shell's exploration to underpin new upstream growth, especially in North America and Australia, with additional barrels from development-led projects."
The news came on the day that Shell released its annual report, which showed that Mr Voser earned less than Tony Hayward, chief executive of rival BP, in 2009. Mr Voser earned a total salary and bonus of £2.8m compared with Mr Hayward's £4m. Shell has said it would freeze management salaries until 2011 after shareholders objected last year when executives were awarded bonuses even after performance targets were missed. Linda Cook, who resigned as head of Shell's gas and power business in May last year, was paid a salary and bonus of £2.1m as well as a severance payment of almost €5.5m (£5m). She leaves with a total pension pot of just under $25m. Mr Voser's predecessor, Jeroen van der Veer, left with a pension pot worth $34.2m.
Shell predicts oil will trade between $50 and $90 a barrel over the next few years and is targeting output of 3.5m barrels of oil equivalent per day in 2012. This compares to 3.15m in 2009, the equivalent to an annual growth rate of 3.5pc, or 11pc in total over three years Mr Voser said the company should be in a surplus cash flow position in 2012, after capital investment and dividend payments – assuming $60 oil prices and a more normal environment for natural gas prices and downstream. In order to achieve this it will have to invest between $25bn and $27 a year in its operations. The Anglo Dutch group also said that it replaced 288pc of its oil and gas output with new discoveries in 2009, or 3.42bn barrels of oil equivalent.