Bridge of Sighs, New York City. Named after a similar span in Venice, this covered passage connected the Tombs prison and Manhattan Criminal Courts building
Ilargi: Say what you will about finance policy decisions coming from Washington since Barack Obama took over as president, they have at least been consistent. No financial institution has been allowed to fail, no executive but Bernard Madoff has been persecuted, and no accounting rule that could potentially be harmful to Wall Street has been left untouched. These policies have put at risk so many trillions of dollars in taxpayer funds that it wouldn’t be terribly surprising if by now literally nobody has been able to keep count.
The main result of it all is a mirage resembling an economic recovery, an image best exemplified by the US stock exchange, the perhaps easiest-to-manipulate segment of the economy. Not that there's no manipulation of data concerning unemployment, foreclosures, home sales or overall productivity; it's just that despite the manipulation, these segments still look awful. And there is exactly zero chance that this will improve in any significant way anytime soon.
If and when the idea takes hold that home prices would seem to stabilize, large numbers of thus far unaccounted-for homes from the 10 million+ shadow inventory will come on the market, quickly overwhelming both demand and price recovery. A similar development will take place if employment numbers appear to pick up: millions will start looking for jobs that have fallen off the radar in the past 2-3 years simply because they had given up all hope. Latent demand is a known economic term; latent supply is just as real. Not counting large numbers of unemployed and large numbers of empty homes is also a type of bad accounting.
The main reason why there is no recovery, despite what anyone might claim, is that there is no way the economy could possibly keep its bearings, let alone recover, without gigantic additional injections of taxpayer money, to the tune of many more trillions of dollars. The present fake recovery does nothing to enhance the real underlying values of the toxic paper and toxic loans that linger inside the vaults of the real economy, many of which can best be typified as zombie vaults.
Since there is no sign whatsoever that the Obama administration has any intentions at all to change its tack, the task of financial truth-finding has now shifted to those markets the government can no longer ignore, and must now turn to in order to finance its rapidly growing debts and deficits: the bond markets. And what a spectacle it promises to be.
The US is set to issue record amounts of Treasuries. But so is about every single other country, And state, and municipality, and many if not most corporations. Will there be enough demand in the international markets for such a supply overdose? Well, yes, sure, as long as the rewards are good enough. The Greek debt that yielded 8% this week is but a perhaps slightly premature messenger of what's to come. US issuance didn't exactly go without a glitch either. Yields reached 4%. And it's only April.
To keep the charade going, Washington has one more trick up it sleeve that may well be known to future historians as the single biggest transfer of public to private capital. Morgan Stanley's analysts foresee a Treasury yield approaching 5.5% by the end of 2010, but there doesn't seem to be any particular reason why it would halt there. It's just about infinitely more important to sell the debt today than to worry about tomorrow's interest payments.
That, combined with the Federal Reserve's resolve to keep base rates at record lows, provides the White House with a neat little scheme that could both make sure its debt is sold, and boost bank capital at the same time. It's not something new, either, but it could be made to grow considerably. Wall Street banks can borrow from the Fed at 0.25%-0.5% right now, then walk a few -virtual- blocks down the street to the Treasury Department, buy Treasuries that yield 4% today and likely much more in the months and years to come, and basically sit on their hands while the money flows in.
This could in theory go on until cracks appear in the walls of the vaults. There is of course the obvious risk that it will steer large amounts of capital away from muni bonds and, especially dangerous for Washington's coveted recovery mirage, the stock markets. However, manipulation of the latter has been going on long enough that the fat cats must feel they have this one down, while municipalities can simply be made to pay a premium over sovereign debt, and too bad boo-hoo-hoo if that starts running into double digits.
Once the inner workings of the scheme become public knowledge, and it may take a while, the defense will be that the end justifies the means, and glorious graphs and stats will be presented, intended to prove beyond a doubt that the recovery works, that Bernanke is a genius worth of an Economics Fauxbel, and that growth is the only way out of the mess the decision makers themselves created.
The only people worse off on account of it all, we the people, won't be able to figure out what on earth has happened until it's about a lightyear too late . And some bespectacled age-old wrinkled wizard will be drawn from behind the curtain to solemnly declare that nobody did foresee, nor even could have foreseen, this terribly unfortunate outcome. And that the theory they based themselves on is still solid as a rock. It’s just that pesky real world that keeps interfering. And now, if he may be excused, he's got a late plane to catch to Paraguay.
There is of course also another outcome possible, what we might call the Dorothy Theory: that someone stands up and insists vigorously to see the wizard at work before he's done manipulating. Experiences of the past few years don't leave all that much hope, however. We find the mirage recovery easier, more appealing and instantly fulfilling than an arduous quest for what the world looks like when it’s not manipulated. And if we keep that up, we won’t find a heart, or courage, let alone a brain. We’ll instead find ourselves broke and broken.
Recovery?!? There's No Recovery! The U.S. Is Completely Screwed!
by Henry Blodget
Retail analyst Howard Davidowitz of Davidowitz & Co. has always been one of our viewers' favorite guests. Howard's flamboyant bearishness won hearts and minds all through the financial crisis, and we--and you--never get tired of hearing from him. But Howard has been bearish for a year now--all through one of the most amazing bull runs in history. Against all odds, the U.S. economy appears to be gathering steam by the day, charging out of the worst recession since the Great Depression and heading toward a strong recovery. So what does Howard think about that? Has he changed his tune? Was he completely wrong? NO WAY!!!
In Howard's view, nothing has changed. Howard thinks the U.S. is still careening down the road toward a hell of fiscal instability, over-indebtedness, ballooning budget deficits and interest payments, and declining living standards. The U.S. is broke, Howard says. The current "sucker's rally" will end up like all the sucker's rallies that have tormented Japan for the past two decades. It will be a false dawn that will momentarily distract everyone from the enormous fiscal challenges we face ... and then reality will take hold again. We won't be able to get out of our pickle without tremendous pain, Howard says. The American people are figuring that out. And the American people won't stand for the status quo anymore.
Pray For Inflation -- It's Our Only Hope
by Peter Gorenstein
Everyone thinks the Fed's job is to fight inflation, but right now the Fed is actually doing everything it can to cause inflation.
It part to help the economy get cranking again. Inflation provides an incentive for people to spend cash rather than saving it, because if they save it, the cash will lose value rapidly.
Inflation also helps solve another problem, though--our debt problem. The more inflation we have, the less our dollars will be worth. Because our debts are based on a specific number of dollars and not a specific value, the less our dollars are worth, the easier it will be for us to pay off our debts.
(Imagine owing someone 100 Zimbabwe dollars at a time when the currency is collapsing. If you wait a week, the value of the Zimbabwe dollar will have collapsed, and you'll be able to pay off your 100 Zimbabwe-dollar debt with currency that is only worth half as much as it was the week before).
The Fed can't admit that one reason it wants high inflation is to reduce the real burden of our debt, but you can bet that that's one of its objectives. What's more, says Nobel-winning economist Paul Krugman, inflation should be one of the Fed's objectives. Because that's how we've gotten out from under debt burdens in the past.
So how did the U.S. government manage to pay off its [World War 2] wartime debt? Actually, it didn’t. At the end of 1946, the federal government owed $271 billion; by the end of 1956 that figure had risen slightly, to $274 billion. The ratio of debt to G.D.P. fell not because debt went down, but because G.D.P. went up, roughly doubling in dollar terms over the course of a decade.
In other words, after World War 2, we didn't "pay down" our debt. We grew into it.
And, importantly, this growth came from a combination of real growth AND inflation:
The rise in G.D.P. in dollar terms was almost equally the result of economic growth and inflation, with both real G.D.P. and the overall level of prices rising about 40 percent from 1946 to 1956.
So inflation is an important tool in getting us out of this mess. It's painful and unfair--those who have been responsible and saved money will pay the price for those who borrowed money, racked up huge debts, and spent more than they could afford. But it's what the Fed is (quietly) aiming for.
1.2 million households lost to recession even prior to 2009
by John Makely
As friends and families double up, ‘overcrowding’ is up fivefold
Since Richard Brown lost his job to the recession and his Boston home to foreclosure a year ago, he’s been working short-term consulting assignments until he gets back on his feet. In the meantime, he’s been “couch surfing.” “I’ve lived with my brother, my cousin, my friend and my dad,” he said. “The IRS keeps calling me, asking me: ‘What’s your address?’ And I say, ‘What week is this?’”
Armed with college degree and an MBA, Brown, 49, built a solid resume over three decades as a corporate controller for several Fortune 500 companies, including W.R. Grace and Wal-Mart, before launching his own global consulting business with clients in Europe and Mexico. But when the Panic of 2008 sent clients scrambling, he was unable to keep up with a jump in his mortgage payments and lost his home to foreclosure.
Brown represents one of the more than 1.2 million households lost to the recession, according to a report issued this week by the Mortgage Bankers Association that looked at data between 2005 and 2008. That number doesn’t include information from 2009, when job losses and foreclosures continued to rise. So it's likely that the full impact of the 8.4 million jobs lost and nearly three million homes foreclosed on since the recession began has taken an even bigger toll on the number of American households.
“Given the depth of the downturn in 2009, and the ongoing weakness in the job market through the beginning of this year, this study gives no reason to expect that household formation has picked up at all," said Gary Painter, a professor at the University of Southern California who conducted the study. The study also shed some light on what happens to the people in those "lost" households. It’s widely assumed that many who lose a home to foreclosure become renters. But since the recession began, there has been a five-fold increase in “overcrowding” of remaining households — defined as more than one person per room, according to the study.
That doubling-up is happening as families who lose their homes move in with friends or family. In other cases, younger people have delayed moving out on their own, instead staying with their parents until the economy improves. Others who fail to find work after graduating from college move back home.
Falling homeownership levels
The decline in households is weighing on both the home buying and rental markets. Since the number of home foreclosures began surging in 2007, the national homeownership rate has been steadily falling. But renters also have been forced to double up or move in with friends or family. That’s a major reason that the vacancy rate for U.S. apartments stood at 8 percent in the first quarter, the highest level since 1986, according to a report this week from Reis, a real estate research firm. The future pace of household destruction or formation is uncertain. A lot depends on how quickly the job and housing markets recover. The outlook for both is mixed.
Though many economists expect the economy to add several hundred thousand new jobs a month as the recovery gains strength, it will likely take years to restore employment to its pre-recession levels. After the 2001 recession, it took four years of job growth to restore a 2 percent drop in employment. This time around employment levels have fallen by 6 percent. Homeownership levels, meanwhile, continue to decline. New foreclosures filings are running about 300,000 a month, according to RealtyTrac. There are currently some 5 million homeowners that are 90 days or more past due on their mortgages, according to Fannie Mae chief economist Doug Duncan.
Though the pace of foreclosures has recently begun to taper off, there are indications they may pick up again as lenders redouble efforts to work out bad loans, and mortgage defaults continue to bring new foreclosures. “Some of the foreclosure backlogs are working their way through the system at this point,” Duncan told CNBC. Millions more homeowners who are current on their mortgages owe more than their home is worth. Though the government recently issued another round of guidelines to lenders urging them to reduce the principal owed on those loans, the process is mostly voluntary.
Rise in homelessness
So far, lenders have been slow to cut the size of a mortgage to make monthly payments more affordable. As a result, an increasing number of families are walking away from their homes in a process known in the industry as “strategic default.” That can become contagious, said Duncan, as neighbors follow suit. “If they see someone else in their neighborhood that walks away, it increases the likelihood they will seriously consider not paying theirs,” he said.
It’s not a move to be taken lightly. The resulting damage to a borrower’s credit history can hurt job prospects with a new employer or create a barrier to renting. In some cases, the loss of a house to foreclosure is leaving families homeless, though there is little national data available on how many are affected. A recent study by the Department of Housing and Urban Development found family homelessness on the rise since the recession began, with the biggest increases in suburban and rural areas.
Other groups, like the National Alliance to End Homelessness, report that a rising number of older adults are without a permanent place to live. “The limited existing research tells a story of increasing homelessness among adults ages 50 and older,” the group said in a recent report. The formation of new households isn’t expected to pick up again until at least 2012, according to the MBA study, even as the population continues to increase. Between 2005 and 2008, those 1.2 million households were lost even as the population grew by 3.4 million.
In the meantime, former homeowners like Brown are left scrambling for alternatives. He recently move into a rooming house where he continues to track down consulting work. “I pay $600 for a third-floor room that gets hot in the summer,” he said. “It’s a blow. I don’t belong here. I’m an educated person. I’ve held executive positions. And here I am in a boarding house where Russian is a first language.”
"Distressed" home sales levels near 2009 peak
by Al Yoon
Sales of foreclosed or other "distressed" homes are flirting with the peaks of the housing crisis in early 2009 when heavy inventory was pressuring home prices lower, according to First American CoreLogic. Distressed sales accounted for 29 percent of all sales in January, the highest since April 2009 and just shy of the 32 percent seen in January 2009, the mortgage data company said on Thursday. Distressed transactions have a strong negative influence on home prices, according to First American, which noted the lows in prices for 2009 coincided with a peak in bank-owned property sales. Distressed sales include short sales, in which lenders allow a home to sell for less than the outstanding debt.
The trend is worrisome to economists who have warned that federal home loan modification efforts and foreclosure moratoriums would result in a backlog of homes hitting the market, forcing prices lower and hurting the economy. This "shadow supply" late in 2009 was estimated at seven million units by Amherst Securities Group. Riverside, California and Las Vegas, Nevada had the largest percentage of distressed sales in January at 62 percent and 59 percent, respectively, First American said.
Davidowitz: Geithner, Summers, Rubin "Buried Our Country ... They Sold Us Down the River"
by Peter Gorenstein
The Financial Crisis Inquiry Commission is trying to turn this week's hearings into a financial crisis blame game. Unfortunately, those that helped create the crisis are reluctant to come clean. Former Citigroup CEO Chuck Prince did say he is "deeply sorry" but former Citi adviser Robert Rubin passed the buck, telling the commission he was largely unaware of Citi's troubled CDO portfolio before September 2007. Alan Greenspan took a similar approach of denial in Wednesday's hearing.
Most former top regulators and Wall Street chiefs won't admit mistakes because "they're still part of the Washington scene," says Howard Davidowitz of Davidowitz and Associates. It's a scene that is too closely linked to Wall Street, Davidowitz says. It also means, in his view, the country will not see meaningful reform until those in control before, during and immediately after the crisis are out of power and the revolving door between Wall Street and Washington is stopped.
"They buried our country, they sold us down the river," he tells Aaron and Henry in the accompanying clip. "They allowed Wall Street and the banks to run wild with our money and take unconscionable risks with our money. And now that it's hit the fan they don't know what happened? It's preposterous."
Sovereign risk spreads: Government Risk Index jumps 40%
by Boyd Erman
Concern about debt repayment is starting again to spread beyond Greece to bigger nations, which could be the "canary in the coal-mine for global risk taking," according to Credit Derivatives Research. “While headlines focused, rightly so, on the debacle that is Greece, it is much more of a systemic crisis in developed nations than most would like to believe," said CDR chief strategist Tim Backshall in a note highlighting a surge in sovereign risk.
CDR's Government Risk Index jumped almost 40 per cent in the last month, its highest since Feb. 25. The GRI is made up of credit default swaps on seven of the largest sovereign debt issuers: France, Germany, Italy, Japan, Spain, the U.K. and the U.S.A. At the same time, investors have been putting risk on in other categories - sending stocks higher until just recently, and hunting for more yield even if it means buying into asset classes long thought dead. "The reach-for-yield-at-all-costs attitude of investors worldwide has reached fever pitch again," Mr. Backshall wrote.
Ilargi: 150 banks added to the problem list in one single quarter. One has to wonder what the FDIC thinks it’s doing closing only one this week.
Myrtle Beach Bank Fails, Year's 42nd
by Judith Burns
Federal bank regulators announced the closing Friday of Beach First National Bank of Myrtle Beach, S.C., making the bank the 42nd U.S. lender to fail this year and the first South Carolina failure in more than a decade. Beach First's seven branches will be acquired by Bank of North Carolina, based in Thomasville, N.C., and its depositors will automatically become depositors of Bank of North Carolina, the Federal Deposit Insurance Corp. said in a statement.
The FDIC said depositors in the failed bank can continue to access their money over the weekend by writing checks, or using automated-teller machines or debit cards, and that loan customers should continue making payments as usual. At year-end, Beach First National Bank had about $585.1 million in total assets and $516.0 million in total deposits. Bank of North Carolina assumed all of the deposits of the failed bank and essentially all of the assets, according to the FDIC. As part of the sale, the FDIC entered into a loss-share transaction with Bank of North Carolina on $497.9 million of Beach First National Bank's assets.
The latest bank failure is expected to cost the FDIC's deposit insurance fund $130.3 million. The FDIC said Beach First is the first South Carolina bank closing since Victory State Bank of Columbia was closed on March 26, 1999. There were 140 bank failures in the U.S. last year, the highest annual tally since 1992 at the height of the savings and loan crisis. They cost the insurance fund more than $30 billion. Twenty-five banks failed in 2008 and only three succumbed in 2007.
The number of banks on the FDIC's confidential "problem'' list rose to 702 in the fourth quarter from 552 three months earlier.
Big Banks Mask Risk Levels by 42%
by Kate Kelly, Tom Mcginty And Dan Fitzpatrick
Major banks have masked their risk levels in the past five quarters by temporarily lowering their debt just before reporting it to the public, according to data from the Federal Reserve Bank of New York.
A group of 18 banks—which includes Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. and Citigroup Inc.—understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods, the data show. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters.
Excessive borrowing by banks was one of the major causes of the financial crisis, leading to catastrophic bank runs in 2008 at firms including Bear Stearns Cos. and Lehman Brothers. Since then, banks have become more sensitive about showing high levels of debt and risk, worried that their stocks and credit ratings could be punished. That practice, while legal, can give investors a skewed impression of the level of risk that financial firms are taking the vast majority of the time.
"You want your leverage to look better at quarter-end than it actually was during the quarter, to suggest that you're taking less risk," says William Tanona, a former Goldman analyst who now heads U.S. financials research at Collins Stewart, a U.K. investment bank. Though some banks privately confirm that they temporarily reduce their borrowings at quarter's end, representatives at Goldman, Morgan Stanley, J.P. Morgan and Citigroup declined to comment specifically on the New York Fed data. Some noted that their firm's financial filings include language saying borrowing levels can fluctuate during the quarter. "The efforts to manage the size of our balance sheet are appropriate and our policies are consistent with all applicable accounting and legal requirements," a Bank of America spokesman said.
An official at the Federal Reserve Board noted that the Fed continuously monitors asset levels at the large bank-holding companies, but the financing activities captured in the New York Fed's data fall under the purview of the Securities and Exchange Commission, which regulates brokerage firms. The New York Fed declined to comment. The data highlight the banks' levels of short-term financing in the repurchase, or "repo," market. Financial firms use cash from the loans to buy securities, then use the purchased securities as collateral for other loans, and buy more securities. The loans boost the firms' trading power, or "leverage," allowing them to make big trades without putting up big money. This amplifies gains—and losses, which were disastrous in 2008.
According to the data, the banks' outstanding net repo borrowings at the end of each of the past five quarters were on average 42% below their peak in net borrowings in the same quarters. Though the repo market represents just a slice of banks' overall activities, it provides a window into the risks that financial institutions take to trade. The SEC now is seeking detailed information from nearly two dozen large financial firms about repos, signaling that the agency is looking for accounting techniques that could hide a firm's risk-taking. The SEC's inquiry follows recent disclosures that Lehman used repos to mask some $50 billion in debt before it collapsed in 2008.
The practice of reducing quarter-end repo borrowings has occurred periodically for years, according to the data, which go back to 2001, but never as consistently as in 2009. The repo market played a role in recent accusations leveled by an examiner in Lehman's bankruptcy case. But rather than reducing quarter-end debt, Lehman took steps to hide it. Anxious to maintain favorable credit ratings, Lehman engaged in an accounting device known within the firm as "Repo 105" to essentially park about $50 billion of assets away from Lehman's balance sheet, according to the examiner. The move helped Lehman look like it had less debt on its books, the examiner said.
Other Wall Street firms, including Goldman and Morgan Stanley, have denied characterizing their short-term borrowings as sales, the way Lehman did in employing Repo 105. Both of those firms also make standard disclaimers about debt. For instance, Goldman disclosed in its 2009 annual report that although its balance sheet can "fluctuate," asset levels at the ends of quarters are "typically not materially different" from their levels in the midst of the quarter. Total assets at the end of 2009 were 7% lower than average assets during the year, the report states.
Some banks make big trades that don't show up in quarter-end balance sheets. That is what happened recently at Bank of America involving a trade designed to mature before the end of 2009's first quarter, people familiar with the matter say. Two Bank of America traders bought $40 billion of mortgage-backed securities from clients for one month, while at the same time agreeing to sell the securities back before quarter's end, according to people familiar with the matter. This "roll" trade provided the clients with cash and the bank with fees.
Robert Qutub, then Bank of America's chief financial officer for global markets, told Michael Nierenberg, a former Bear Stearns trader who oversaw the traders who made the roll trade, to cap the size of the short-term transaction, people familiar with the matter say. A week later, however, the amount tied to the trade shot up to $60 billion, these people say, before dropping to $25 billion, one of these people said, appearing to some at headquarters that the group had defied the order to cap the trade. A bank spokeswoman said "the team was aware of and worked within its risk limits."
Bundesbank attacks Greek rescue as a threat to stability
by Ambrose Evans-Pritchard
Germany's Bundesbank has fired a warning shot at Chancellor Angela Merkel, attacking the joint EU-IMF rescue plan for Greece as a threat to economic stability and probably illegal. Leaked extracts from an internal report appeared in the Frankfurter Rundschau and may have contributed to a fresh day of mayhem for Greek bonds. Investors were already digesting reports that Greek residents had shifted €10bn (£8.8bn) abroad over the first two months of the year. The yield on two-year Greek bonds surged by 136 basis points in early trading to 8.3pc, up from 5.2pc last week. The market stabilised later as Athens announced a 40pc cut in the budget deficit over the first quarter, suggesting that austerity measures are bearing fruit.
The Bundesbank document offers a withering critique of the deal agreed by EU leaders two weeks ago, saying the plan had been cobbled together without consulting central banks and will lead to monetisation of debt. "It brings problems in respect to stability policy that should not be underestimated." The joint rescue between the IMF and the EU would turn the Bundesbank into a "money-printing machine" for the purchase of Greek bonds, according to Rundschau. This would breach the EU's 'no-bail clause'. Hans Redeker, currency chief at BNP Paribas, said the report greatly strengthens the hand of EMU critics in Germany. A group of professors is already itching to file a complaint at the constitutional court to block the Greek rescue. "This reduces Merkel's room for manoeuvre to zero," he said.
The Bundesbank, headed by ultra-hawk Axel Weber, said the decision to bring in the IMF makes matters worse, arguing that the EU would impose tougher budgetary discipline. The report mocked the IMF as the "Inflation Maximising Fund", saying the body had gone soft under Dominique Strauss-Kahn, a French socialist and Keynesian. It has shifted focus from fiscal cleansing to "growth-oriented" financial policies. "Currency reserves from the Bundesbank cannot plausibly be made available for such purposes," it said.
At the least, it will be hard for Mrs Merkel to relax her insistence on "market rates" for any loans to Greece. Officials have talked of a figure near 6pc to avoid moral hazard but this has angered Greece. It hopes to borrow below 4.5pc like Portugal or Ireland. A Greek government spokesman said yesterday that "barbarous conditions" were being imposed on his country. Jean-Claude Trichet, the president of the European Central Bank, played down talk of a continued rift between Berlin and Brussels, saying the EU agreement to help Greece was "a very, very serious commitment: nobody should take lightly a statement which is signed by the heads of state." "Taking all the information I have, a default is not an issue for Greece," he said, speaking after the governing council's meeting. The bank left rates at a record low of 1pc.
Laurent Bilke, Europe economist at Nomura and a former ECB official, said Greece is effectively shut out of the market. "We consider it increasingly likely that the Greek government will be forced to change strategy and ask for a rescue. There is really no point waiting for an 'accident' to happen." Barclays Capital said any rescue would have to be at least €40bn-€45bn to restore confidence and provide Greece the funding it needs to buy time for reform. As expected, the ECB delayed plans to tighten to its collateral rules, eliminating the risk that Greek banks will lose their lifeline from Frankfurt's lending window for another year. The IOBE think-tank said ECB funding for Greek banks has risen to €65bn over the first quarter. ECB will impose a penalty "haircut" on lower grade bonds, but not sovereign debt. This is a subtle way to help Greece and Italy and other big debtors.
Julian Callow at Barclays said the Greek gyrations have disguised the good news that contagion has not spread to Club Med and Ireland. "Greece is being treated as a case apart because it entered the crisis with a debt that was already so high. Ireland has managed to insulate itself despite the costs of its banking sector," he said. If anything, the eurozone looks stronger after the events of the past two weeks. Analysts say there is no necessary reason why a Greek default – if it happened – would in itself damage monetary union.
Greek Bank Credit Ratings Cut by Fitch on Sovereign Downgrade
by Christine Harpe
National Bank of Greece SA and four other Greek lenders had their credit grades slashed today by Fitch Ratings after the credit firm downgraded their home nation’s sovereign rating. The changes “reflect Greek banks’ debilitated risk profile, particularly regarding their liquidity and funding position as a result of increased sovereign concerns,” Fitch said in a statement. “The banks will be challenged to maintain their present liquidity profile given current market volatility.”
Fitch, one of the three biggest credit rating firms, lowered its assessment of Greece’s creditworthiness earlier in the day by two notches to the lowest investment grade and said the outlook remains negative. European Union officials responded by saying they are ready to rescue Greece if needed. Ratings on National Bank of Greece, the nation’s largest, along with EFG Eurobank Ergasias, Alpha Bank A.E. and Piraeus Bank SA were reduced by one notch to BBB-, the lowest investment-grade rating, and Fitch said the outlook remains negative. Agricultural Bank of Greece’s long-term rating was cut to BB+, the highest junk rating, from BBB- and was also placed on rating watch negative.
The banks’ deposits have declined by 2 percent to 4 percent in the three months that ended in March amid “elevated risk perception” surrounding Greece, Fitch said. The support rating floors on the five banks was also lowered to BB from BBB- as Fitch decided that the prospect of government help is more remote. “While in Fitch’s opinion the Greek government’s propensity to support banks remains, its ability to support them has been markedly reduced,” Fitch wrote. “Its ability to provide significant levels of support is itself likely to be dependent on the external provision of support” from the euro area and the International Monetary Fund. As of the end of December, the five banks had total assets of about 350 billion euros ($472 billion), according to data compiled by Bloomberg. National Bank of Greece, had 113.4 billion euros in total assets.
Europe Said to Firm Up Terms of Greek Loans
by Jack Ewing and Stephen Castle
European Union officials firmed up plans on Friday to keep Greece from going off a financial cliff, as deputy finance ministers outlined terms to help the country borrow at below market rates. Heads of government including President Nicolas Sarkozy of France also offered words of support. An European Union official confirmed reports that financial officials in Brussels had struck an accord on the technical details of a possible loan for Greece. The terms would be similar to those offered by the International Monetary Fund, allowing Greece to pay sharply lower interest than the 7.5 percent that markets were demanding earlier this week. The European Union official spoke on condition of anonymity because of the sensitivity of the issue.
The discussions in Brussels appear to have resolved one complex impediment to a refinancing of Greek debt: constructing loan terms that get around German opposition to any financing that could be considered a subsidy or bailout. But German officials, illustrating a continuing split among European Union countries, insisted that Greece does not yet need help and described the work by the deputy finance ministers in Brussels as contingency planning. “There is no recognizable emergency,” Michael Offer, a spokesman for the German finance ministry, said in a telephone interview.
Elsewhere in Europe, leaders tried to reassure investors after the Fitch ratings agency downgraded Greek debt, adding to the enormous pressure on the country. “We are ready to take action at any moment to come to the aid of Greece,” Mr. Sarkozy said at a news conference, according to Reuters. Comforting words also came from Silvio Berlusconi, prime minister of Italy, and Herman Van Rompuy, president of the European Union. Greece needs to raise 30 billion euros ($40 billion) by the end of May, economists at UBS, the Swiss bank, estimate. The country could run out of cash in as little as two weeks, the economists said in an April 8 report.
Reuters, quoting an unidentified person, reported that the agreement would require Greece to pay a relatively high rate of 6 percent interest on aid from other European Union countries. The rate would be even higher for loans longer than three years, Reuters reported. Members of the 16 countries could announce the terms next Friday, Reuters reported, and earlier if needed. An monetary fund loan would normally carry an interest rate closer to 4 percent. But officials in Brussels cautioned that any understanding on Greek aid would first require agreement by the finance ministers of the euro zone, then by national leaders. When the finance ministers made their first agreement on a support mechanism for Greece last month, Chancellor Angela Merkel of Germany, later insisted on attaching much tougher terms.
Any refinancing package would also require a formal request from Athens, then agreement of the 16 euro-zone countries. Still, progress appears to have been made when deputy finance ministers or state secretaries of the European governments met in Brussels, with a gathering of representatives from the 16 euro-zone nations taking place in the sidelines. Cristina Gallach, a spokeswoman for the Spanish presidency, confirmed that the meeting had taken place and added that there was “no more public information about the details of discussions relating to Greece.”
Another official said, however, that the interest rate would be based on the framework offered by the International Monetary Fund, which would typically, for a three-year loan, add 300 basis points plus a surcharge of 50 basis points on top of its Special Drawing Rights rate. But in the case of Greece, the S.D.R. rate would be replaced by the Euribor rate — that at which euro interbank term deposits are being offered by one prime bank to another within the euro zone. Over all, the arrangement typically allows countries to borrow at rates several percentage points below the market level, while attaching tough conditions on spending and requiring government overhauls.
Greece’s problems ultimately stem from a long history of government inefficiency and corruption, as well as an economy that can no longer compete globally, analysts say. The country’s problems ultimately stem from a long history of government inefficiency and corruption, as well as an economy that can no longer compete globally. Under one possibility, the monetary fund would allocate up to $10 billion, with additional funds from the European Union. But the monetary fund, based in Washington, would attach tough conditions, including pension overhauls, improved tax collection, increasing the retirement age, reducing the cost of firing workers and changing its practices for collective bargaining.
A third European official said that, by sticking closely to the terms offered by the monetary fund, the European Union may have helped ease German opposition to any subsidized loans because the fund is the lender of last resort. Sticking to its terms could provide Berlin with political cover, the official argued. The yield on 10-year Greek bonds, which spiked at 7.5 percent on Thursday, eased Friday. Global stock markets also rose.
Mr. Offer of the German finance ministry said that Greece continued to have access to financial markets, though he acknowledged the turmoil. “The Greeks haven’t asked for help,” he said. Spokesmen for Mrs. Merkel and the German Bundesbank, which would be a conduit for Germany’s share of any aid, endorsed Mr. Offer’s comments. Fearful of alarming financial markets, Greek government officials on Friday avoided commenting on reports of an agreement in Brussels. A government official confirmed that Prime Minister George Papandreou had been speaking to European counterparts by telephone about current developments.
Euro Advances on Expectations Greek Aid Is Near
by Bradley Davis
The euro shot higher amid talk of an imminent bailout package for debt-strapped Greece, helping to boost demand for riskier assets including stocks and most commodities. In volatile trading, the common currency had strengthened 1.1% by late afternoon, rebounding from a brief intraday dip after Fitch Ratings downgraded Greek debt to near-junk status to brush up against $1.35 even as no solid plans for a bailout emerged.
"It certainly is possible that [a rescue package] happens over this weekend," said Daragh Maher, deputy head of global foreign-exchange strategy at Credit Agricole CIB in London, noting a solid plan would at least temporarily lift the euro and calm investor nerves by bringing "greater clarity in the market." By late afternoon in New York, the euro was at $1.3471, compared with $1.3349 late Thursday.The move snapped a five-session win streak for the dollar. The buck also weakened to 93.23 yen from 93.36 yen. The euro strengthened to 125.59 yen from 124.63 yen. The U.K. pound was at $1.5371 from $1.5267. The dollar moved to 1.0663 Swiss francs from 1.0739 francs.
The euro began its rise overnight on speculation that Greece would receive financial help from the EU and the International Monetary Fund as soon as the weekend, which helped calm fears of an escalating debt crisis and led to narrower spreads on Greek government bond yields. A report from Medley Global Advisors supported the notion EU officials have agreed on terms for funding a backstop deal for Greece, helping the common currency extend its gains. But an EU official said details of any financial aid were still being worked out and a German government spokesman said "the state of play and decision on Greece is unchanged."
Reports of a new bailout plan are "incredibly baffling," said Sebastien Galy, currency strategist at BNP Paribas. "I think it's way too early right now even for this short-term rally." The euro rally briefly stalled after Fitch cut Greece's debt rating to BBB- from BBB+. Greece faces €11.6 billion ($15.7 billion) in debt coming due next month. As a result, the euro's bounce is likely to be short-lived, traders said. "The euro is unlikely to recover any significant ground while the Greek issue continues to hang over the markets," strategists at TD Securities wrote in a note to clients.
Speculative investors pared their bets against the euro 21% in the week ended Tuesday, according to an analysis by Scotia Bank, but antieuro bets still remain at near-record levels and investor sentiment toward the common currency was significantly negative, said Camilla Sutton, Scotia currency strategist in Toronto. Meanwhile, the U.K. pound strengthened on the dollar, buoyed by generally rosier investor sentiment that helped extend sterling's rally on the back of fresh, stronger-than-expected U.K. inflation data.
Retail Sales Up but America in "Dramatically Worse Shape" vs. a Year Ago, Davidowitz Says
by Aaron Task
Optimists cheered Thursday's stronger-than-expected March sales at retailers such as Kohl's, Nordstrom, The Limited and even Gap as further proof of an improving economy and rebounding U.S. consumer. In fact, Thomson Reuters' Same-Store Sales Index rose 9.1% last month to the highest level in the index's 10-year history.
"The numbers were very strong," admits noted cynic Howard Davidowitz of Davidowitz & Associates. "There are some positives" in consumer spending, even after adjusting for the boost many retailers got from Easter being earlier in April this year vs. last.
But (you knew that was coming, right?), Davidowitz believes it's a "sucker's rally" in retail stocks and any rebound in consumer spending will be short lived. "We're in a bad place, heading for a worse place," he says.
Regarding today's chain-store sales data, the veteran analyst notes huge retailers were excluded, most notably Wal-Mart. "When you look at comp retail sales they don't include the giants, they include some little dinky apparel chain doing a billion-five [in sales] and these analysts are dancing in the street."
Furthermore, retailers such as Macy's and Target warned the big jump in March sales would likely take a bite out of results in April, while Abercrombie & Fitch was a notable laggard in March; the Retail SPDR was essentially flat at midday.
More importantly, Davidowitz says the financial condition of the country is in "dramatically worse shape" than it was a year ago, when he was making dire predictions about America's future.
With "no real jobs growth...deficits gone mad" and prospects for higher taxes for all Americans, Davidowitz is "exactly in the same place" as a year ago, despite the economy's apparent revival. "There's clearly pent up demand - there are needs [and] the consumer is jumping on those needs," he says. "We're in a cyclical economy. That doesn't mean we're better off."
As hinted in the accompanying video, Davidowitz is highly critical of the Obama administration and predicts big political changes for America, as we'll discuss in more detail in a forthcoming segment.
State, Local Budget Woes To Continue
by Conor Dougherty
State and local governments will continue to face budget squeezes long after the economic recovery is well established, as costs rise and tax revenues lag, according to tax experts gathered here for a conference. State and local governments have seen their tax revenues hit hard by the recession, with drops in sales, income and other taxes on which they rely. State and local tax collections fell 6% in 2009, the largest yearly percentage decline on record. "State and local governments see themselves in a full-blown cyclone," said Ronald Fisher, an economics professor at Michigan State University.
Governments have responded with tax increases, employee furloughs and social-service cutbacks, among other steps. Still, the 50 states face midyear budget gaps of a combined $35 billion. A paper presented by Mr. Fisher at the forum of economists at Washington University in St. Louis showed that many state governments face longer-term revenue problems that have resulted from a narrowing of the tax base. This decline in the tax base can be traced, in part, to an aging population, which pays lower tax rates on retirement income while still consuming the full range of public services.
According to another paper presented here, the $787 billion federal stimulus program has been largely ineffective at plugging state and local budget gaps in part because it was doled out evenly among states instead of giving more to states with the worst deficits. Robert Inman, author of that paper and an economics professor at the Wharton School at the University of Pennsylvania, said the point of the stimulus act, about a third of which was allocated to state and local government support, was to get hundreds of billions of dollars into the economy as fast as possible and with an even distribution among states.
Therefore states with the worst deficits—California and New Jersey, for instance—didn't get enough to plug their holes. Meanwhile, resource-rich states like Texas, Wyoming and North Dakota that have had tamer budget problems got more than they needed. "If your objective is budget insurance it's not a particularly good program," Mr. Inman said in an interview.
$26 Million Surprise Revenue Offers Los Angeles Temporary Reprieve
by Peter Sanders
After a week of dire predictions, city officials here said an unexpected $26 million of new revenue will help stave off an immediate fiscal crisis, but serious longer-term financial problems remain. The windfall—the result of better-than-expected property-tax revenue and cost-saving moves—couldn't come at a better time. Earlier this week, Los Angeles Mayor Antonio Villaraigosa had warned that he might try to shutter some city offices two days a week in order to help bridge an estimated $222 million deficit in the current fiscal year, which ends June 30. The city's controller, Wendy Greuel this week also warned that the city had been set to run out of cash as early as next month.
The unexpected revenue bump also follows a rare spate of good news from the state capitol, where California's controller said Thursday that the state's coffers in March received $356 million more than had been projected, owing to increased revenues and decreased expenses. "March numbers were strong on both sides of the ledger," Controller John Chiang said in a statement. "But the state's nagging unemployment rate, combined with the fact that personal-income-tax revenues are trailing last year's by nearly $1 billion, tells us the road to recovery will be long and arduous."
Los Angeles still has a long way to go to dig itself out of its massive fiscal hole. The city's budget deficit is expected to grow to $485 million in the coming fiscal year, which begins on July 1. The city still plans to transfer $90 million from its reserve fund to its general budget in order to pay expenses and payroll through June, officials said. And they said they would continue to press the powerful municipal utility to transfer $73.5 million, which it has been withholding from the city.
On Monday, the Los Angeles Department of Water & Power, the nation's largest municipal utility, said it couldn't afford to transfer the funds to the city because the city council had refused to approve electricity rate increases the department said it needed. That has kicked off a bitter fight between the city council, which is demanding the money, and the DWP, which is still refusing to hand it over.
Crawling out of the hole will be a long-term project. "In L.A. there are multiple centers of power with multiple priorities, and getting them to agree on one plan is an incredibly difficult process, which works better in the long term than when you're in a crisis," says Fernando Guerra, professor at Loyola Marymount University in Los Angeles. "In a crisis we need unitary power, but the city of Los Angeles doesn't have that."
Illinois' unpaid bills could top $5.5 billion by summer
by Chris Essig
The volume of Illinois' unpaid bills will likely increase by $1 billion in the next three months, according to a new report. By the end of June, the backlog of unpaid bills could exceed $5.5 billion "absent any other developments," noted Comptroller Dan Hynes, in a quarterly report on the state's finances. Now, the state's 200,000 unpaid bills total $4.5 billion. The report warned the increase in unpaid bills could lead to "further erosion of the state service infrastructure." Many providers will be unable to continue at current state funding, affecting vulnerable citizens across the state.
"The ability to operate state programs for children, seniors, and the disabled will become increasingly impaired," the report said. At least one vendor is already cutting their contract with the state because of it's inability to pay its bills. Two weeks ago, a state ammunition vendor refused to ship bullets to the Illinois Department of Corrections unless the company was paid up front. The vendor, Shore Galleries Inc., was owed $6,000 by the state. The department was forced to make an emergency purchase of bullets from an out-of-state vendor.
Currently, the comptroller's office has $2 billion worth of critical bills each month that must be paid off first. These include payments towards debt service, Medicaid, schools and payroll. That doesn't leave much money left over to pay down the state's unpaid bills. Meanwhile, the comptroller's report is not putting much faith in the ability of lawmakers to correct the problem before they adjourn in May. "There appear to be limited options left for the remainder of this fiscal year to substantially mitigate these conditions," noted the report. "And the outlook for fiscal year 2011 is even more ominous."
Get Ready To See US Banks Stuffed With An Epic Volume Of US Debt
by Joe Weisenthal
Some more wise thoughts on the US funding challenge, this time from Richard Benson of boutique bank Specialty Finance Group:
There's no doubt where the Treasury will turn for finance. We are about to see the greatest stuffing of banks with government securities the world has ever seen. American banks will be forced to gorge on Treasury securities, and disgorge bank reserves. Where else can the government get the next trillion to spend on things like wars, unemployment benefits, and food stamps?
There are a few obvious things to think about here. At the rate of $120 billion a month, it will only take about nine months to blow through over a trillion dollars in free bank reserves. Each Treasury auction will find it more difficult to sell all of the treasury securities, and it will take rising interest rates to coax out even more reserves from the banks. (When you need to borrow over $4 billion a day, even a trillion dollars doesn't last long.)
By the end of the year, when the bank reserves are used up buying Treasuries, interest rates will soar and bond auctions will start to fail. No one will have any cash left to buy Treasuries unless, of course, central banks crank up the printing presses again. Look for a QE II, QE III, and QE IV before the dust settles. Without central banks, there really isn't any source of debt buying large enough to fund America's deficits.
Looking in the crystal ball that reflects the truth of what our government is up to, our choices appear to be:
* inflate, or watch interest rates soar;
* watch interest rate soar, and inflate; or
* inflate the money supply and ultimately drive interest rates relentlessly higher.
Either way, interest rates, particularly longer term, will constantly be pushed up, while future rounds of money printing will surely promise great inflation in the years to come. Endless deficits of this magnitude do have serious consequences.
The Risks and Returns of Municipal Bonds
by Paul Sullivan
Municipal bonds are among the few tax shelters left for high-net-worth investors, but many of the entities backing them — cities, states and public works projects — are in such fiscal trouble that many investors are taking a closer look at these historically secure securities. As Mary Williams Walsh wrote last week in The Times, some states have taken extreme steps to balance their budgets in the face of declining revenue and rising bills. These include Hawaii going to a four-day school week, Connecticut trying to create its own accounting rules and California making companies pay 70 percent of their 2010 tax by June 15.
If any company had initiated similar shock measures, its bond holders would have probably fled. But Brad Gewehr, head of fixed-income research at UBS Wealth Management Americas, said March nearly set a record for new municipal bond sales. To add to investor confusion, one of the main credit rating agencies has re-evaluated how it rates municipalities, resulting in higher ratings even for California, the state often ranked as the worst fiscally. There is a logical explanation for this. Municipal and corporate bonds have been held to different criteria, and this readjustment is meant to rectify that. But the timing is at best counterintuitive.
“Initially, I don’t think someone is going to wake up and say California is an A1 and everything has changed,” Mr. Gewehr said, noting that the state’s rating has risen three notches under the new criteria. But it does raise a question: What are the real risks of holding municipal bonds when states and municipalities are struggling to pay their bills?
The reality is that municipal bonds have a historically minuscule default rate. Even in California, the state’s constitution says bond holders are second only to primary education to be paid from tax receipts. “We would not assume that any state can’t go under,” said Gregg Fisher, chief investment officer of Gerstein Fisher, an investment advisory firm. “If the government bailed out a bank, don’t you think they’d bail out a state?”
But there is another more pressing issue than an outright default: what happens if an investor wants to sell the bonds before the maturity date? Right now, given the fiscal problems in some states like California, New York, Florida and Illinois, it could be difficult to sell the bonds for close to their original price. “I sold a Philadelphia bond this morning and I was kissing the ground that I got 85 cents on the dollar,” said Mary P. Talbutt-Glassberg, vice president and fixed-income portfolio manager at Davidson Trust Company. Getting less than you paid for a security is always a risk. But Ms. Talbutt-Glassberg said that even investors who held their bonds to maturity could be in for a surprise if the municipality’s finances deteriorated.
“What if when the bond matures, they hand you another one?” she said, of a forced rollover into a new bond to pay off the old one. “What do I do if I needed the money for college tuition?” While people who own munis issued by the state where they pay taxes get a bigger tax break then those who hold the bonds of another state, there is a greater case now to forgo some of that tax benefit for broader diversification.
IS THE MARKET RIGHT?
The prevailing thinking is still that all the bad news about municipalities has been priced into the bonds. This has led to two lines of thought. The first is that this is a great time to buy municipal bonds, because things can only get better. “The market’s taking its cue from California and pricing these bonds as if they’re a lot more likely to default than they are,” said Milton Ezrati, senior economist at Lord Abbett. By his reckoning, any small improvement in a municipality’s finances could quickly raise the prices of its bonds.
The second argument, perhaps not surprisingly, is that this is a risky time to buy municipal bonds. While Marilyn Cohen, president of Envision Capital Management in Los Angeles, agreed that the market had reacted quickly to bad news, she disagreed on the amount of improvement needed to raise the outlook for municipal bonds. “Any minor improvement will be a godsend, but it will have a small impact,” she said. “Everything is not going to be all right.” The condition of public finance is such, she said, that a bond price moving up does not mean all is well.
Where both camps agree is on the need to be more selective in picking municipal bonds. George Strickland, managing director at Thornburg Investment Management, which focuses on municipal bonds, said default rates were historically high in 2008 and 2009. They were still well under one-half of 1 percent, but he is being more selective in what he buys. “There are a lot of moving parts right now,” Mr. Strickland said. “The city of Los Angeles says it’s running out of money and won’t be able to pay its bills, and Harrisburg and Detroit are flirting with bankruptcy.”
WHAT ARE MUNIS FOR?
The credit crunch showed that even safe assets are not as safe as we think. People who put their money in the Reserve Primary’s money market fund found this out the hard way when they could not withdraw their cash in September 2008. Municipal bonds have historically been desirable because of both their safety and tax savings. Even now, Mr. Fisher argued, they have lower risk. He calculated the returns from the peak of the economic cycle in October 2007 to February 2010 if an investor had divided his assets in the classic split of 60 percent stocks to 40 percent bonds.
The 60 percent tracked the S.& P. 500 index. But he put the 40 percent in a three-year municipal bond fund and also in a long-term corporate bond fund. Rebalancing the portfolio quarterly, the results were nearly identical: with the muni fund, the portfolio was down 3.53 percent and with the corporate bond fund it was down 3.58 percent. And that was before the tax benefit from the municipal bonds was factored in.
“The returns were the same, but the risks were a lot more with corporate bonds and the taxes were higher,” Mr. Fisher said. “Our view is the purpose of owning fixed income is to reduce risk.” Regardless of what states do to get their fiscal houses in order, federal taxes are still set to rise next year. That will keep municipal bonds an attractive tax shelter for wealthy investors — if they choose carefully.
Two Treasury Forecasts: a Grand Canyon-Size Gap
by Mark Gongloff
Goldman and Morgan at Odds as Yield Forecasts Paint Picture of Uncertainty
Investors befuddled by dramatic moves in the 10-year Treasury yield won't get much help from the sages of Wall Street. Some of the smartest prognosticators are sharply divided on the direction of Treasurys, a split echoed by the gyrations of the yield itself. This week, the yield swung from just above 4% on Monday to as low as 3.84% on Thursday and back to as high as 3.93% on Friday as investors were alternately fearful and sanguine about the market's willingness to digest the U.S. government's record supply of new debt.
Meanwhile, the two best economic forecasting teams of the past two years couldn't disagree more about where Treasurys will go next. Morgan Stanley believes the 10-year yield will rise to 5.5% this year, the highest estimate among top Treasury dealers. Goldman Sachs Group Inc. says yields are headed back down to 3.25%.
The 2.25 percentage-point gap between those forecasts represents a gulf when it comes to corporate, consumer and government borrowing costs. Where Treasurys wind up could hold the key to the pace of the economic recovery—and the direction of the stock market—given that a strong economy might be able to withstand a spike in rates but a shaky economy might not. Goldman's forecast, for example, would put mortgage rates, which theoretically move in step with 10-year Treasury yields, at about 5%, their generational low. Morgan Stanley's forecast would put them somewhere north of 7%, the highest in a decade.
Since 2003, Treasury yield forecasts by economists have differed more only in late 2008 and early 2009, when the credit crisis was raging and the economy was an even bigger question mark, according to tallies by The Wall Street Journal surveys of economists. And seldom have the best forecasters been so far apart. Morgan Stanley's economic and rate forecasts were No. 1 in 2009, while Goldman led the pack in 2008. The second-ranked forecasters in 2008 and 2009 don't agree, either. Kurt Karl of Swiss Re, last year's No. 2, sees the 10-year yield ending 2010 at 3.8%. And 2008's No. 2, Ram Bhagavatula, of Combinatorics Capital, thinks the yield will rise to 5%.
At Morgan Stanley, head of interest-rate strategy Jim Caron reasons that the market can't withstand an estimated $2.4 trillion of debt the U.S. government is expected to sell this year without yields rising. Because yields move inversely to price, they go up as prices decline. "We've never seen this much Treasury supply in the history of the bond market," Mr. Caron said in a phone call this past week. Morgan Stanley's strategists and economists, including Richard Berner and David Greenlaw, also take into account a view that the economy, private credit demand and inflation expectations will rebound more quickly than many analysts expect.
In some respects, Morgan Stanley's view looks extreme: 5.5% would be the highest yield since May 2001. That was two recessions, two stock-market bottoms and one real-estate bubble and bust ago. In comparison, the broad consensus is that the 10-year yield will rise to just 4.24% by year's end, according to the latest Wall Street Journal survey of economists. "I never really thought about [our forecast] as being the outlier," Mr. Caron said. "In our view, the consensus is wrong."
At the other extreme, Goldman's view is that record government borrowing is merely replacing missing private credit demand, which will return slowly. Even without a double-dip recession, unemployment and other measures of economic "slack" will stay high, snuffing inflation, which is typically a key driver of interest rates, Goldman predicts. "Ultimately, we don't find supply to be of such great predictive power regarding what happens to interest rates," said Goldman Sachs economist Jan Hatzius.
The divergence of views between Morgan Stanley and Goldman is reflected in debates taking place around the world, including the boardroom of the Federal Reserve. Economic iconoclasts Jim Grant and David Rosenberg recently debated the subject in a video enjoying heavy Internet rotation this week. "You'll find more bargains in your hotel mini-bar than you will in the Treasury yield curve," said Mr. Grant, editor of Grant's Interest Rate Observer. "You don't go through bear markets in Treasurys unless the Fed is tightening monetary policy, which I frankly believe is years down the road," countered Mr. Rosenberg, chief economist at Gluskin Sheff in Toronto.
After this past week's rebound, including an auction Wednesday that brought the highest demand for 10-year Treasurys since 1994, the momentum is on the side of the Treasury bulls, if only for now. And Treasury yields are still lower than before the recession began in 2007, despite record government borrowing and budget deficits. This isn't unprecedented. David Ader, head government-bond strategist at CRT Capital, recently noted that government borrowing costs have fallen in Canada, Japan and the U.K. even as those countries racked up hefty budget deficits.
Even if supply alone is enough to drive rates dramatically higher and the economy isn't strong enough to handle it, then the recovery could be at risk, at least in housing. That could hurt the economy or lead the Fed to ramp up its Treasury purchases, either of which would drive yields lower. But the case by Treasury bears for higher rates depends partly on an expectation that the economy can handle it. Though the 1.65 percentage-point jump in yields Morgan Stanley expects this year would be unusually large, it isn't unprecedented. In fact, Treasury yields surged 1.6 percentage points last year, and the economy managed to recover anyway.
UK national debt picture is unclear: Evercore
by Joy Dunbar
If the UK was a company it would have up to £4 trillion of debt compared to an income of £1.4 trillion, according to John Redwood MP.
Mr Redwood, who is chairman for Evercore Pan Asset Capital Management, said at the launch of two of its funds at the Natural History Museum in London, that the government's stated borrowings were £850bn. However, government figures do not include other liabilities, according to Mr Redwood, including: unfunded pensions obligations of more than £1 trillion; £300bn of private finance initiatives and public private partnerships; and gross and net banking liabilities of less than £2 trillion, and the government that comes in after the general election has to deal with these debts.
Mr Redwood said that the UK plans to borrow £1 in every £4 it spends this year, taking borrowing to 12.5 per cent of national income. He said: "We are not very keen on UK government bonds unless we see an attempt to cut the public deficit. If markets lose confidence you can lose a lot of money, the UK already has to pay 100 basis points more than Germany for its bonds." One of the causes of the credit crunch was that credit was greatly over extended which resulted in property and other assets being in bubble territory, according to Mr Redwood.
He said: "The authorities hiked interest rates and reduced the money growth. By August and September of 2007 money markets were starved of funds. "This started to topple banks and other institutions that needed access to money market money. The authorities carried on tightening for a further year, bringing on the bigger crash of late 2008." When Mr Redwood was asked about the likelihood for a hung parliament, he said: "There are four potential outcomes: a Conservative or Labour majority government or a Conservative or Labour minority government.
"The markets have not yet priced in any of those scenarios with any certainty. A Labour or Tory government would tackle the deficit. A UK prime minister does not have to resign if he loses a general election, he just has to ensure that a vote can get through the House of Commons." Last week, Evercore Pan Asset Capital Management launched its PanDYNAMIC Balanced, which is a medium risk fund, and PanDYNAMIC Growth, which is a medium to high risk fund. Christopher Aldous, chief executive for Evercore, said: "We make active or dynamic decisions about which asset classes to invest in and when to buy and sell them. "Once we have made our asset decisions we use exchange traded funds to track the index which most closely follows the asset."
Art Cashin: Market Conspiracies Point To Secret Fed and ECB Actions
by Gregory White
Art Cashin of UBS spoke on CNBC late yesterday about what he, and many traders on the floor, are thinking about treasury auctions and actions in the euro. Conspiracies abound.
- 0:15 Easing of the currency pressure turned markets around on Thursday
- 0:30 Some think that the Fed is coming in as a buyer for 30-year treasuries
- 0:50 Some also suspect the European Central Bank of entering the market to prop up the euro
- 1:38 The drain on Greek banks continues to have investors concerned
Remember That Huge Gift Obama Gave To The Auto Unions? Now We're About To Pay For It Dearly
by Megan McArdle
The Government Accountability Office has a report out today on the unfunded liabilities of the GM and Chrysler pensions. The most controversial aspect of the bankruptcy reorganizations orchestrated by the Obama administration is that the companies reaffirmed their obligation to their retirement plans, which are often terminated when a company undergoes a bankruptcy.
For the most part, the terms of the restructuring called for current levels of employee benefits-- including pension benefits--to remain in place for at least 1 year. Specifically, the master sale agreements for both companies stipulate that, in general, union employees are to be provided employee benefits that are "not less favorable in the aggregate" than the benefits provided under the employee pension and welfare benefit plans, and contracts and arrangements currently in place; nonunion employees are to receive current levels of compensation and benefits until at least 1 year after the date the agreements are signed.
A lot of people--including me--regarded this as a gift to the UAW, at the expense not only of the bondholders who had lent the firms money, but also of the company's future chances at profitability.
The GAO report offers a rather dour picture of the plans' funding status:
Nevertheless, according to GM's projections utilizing valuation methods defined under PPA, large cash contributions may be needed to meet its funding obligations to its U.S. pension plans beginning in 2013 (see fig. 4). GM officials told us that cash contributions are not expected to be needed for the next few years because it has a relatively large "credit balance" based on contributions made in prior years that can be used to offset cash contribution requirements that would otherwise be required until that time.47 As of October 1, 2008, GM had about $36 billion of credit balance in its hourly plan and about $10 billion in its salaried plan. However, once these credit balances are exhausted, GM projects that the contributions needed to meet its defined benefit plan funding requirements will total about $12.3 billion for the years 2013 and 2014, and additional contributions may be required thereafter. In its 2008 year-end report, GM noted that due to significant declines in financial markets and deterioration in the value of its plans' assets, as well as the coverage of additional retirees, including Delphi employees, it may need to make significant contributions to its U.S. plans in 2013 and beyond.
Similarly, Chrysler's management expects that contributions to meet minimum funding requirements may begin to increase significantly in 2013, but are projected to be relatively minimal until then (see fig. 5). Chrysler, like GM, intends to use credit balances to offset the contribution requirements for some of its plans. As of end-of-year 2009, Chrysler had credit balances of about $3.5 billion for its UAW Pension Plan and about $1.9 billion across the other eight plans for which it provided funding information. In addition, Chrysler also has $600 million in payments from Daimler to help meet its funding requirements over the next few years.49 Nevertheless, Chrysler's funding projections reveal that about $3.4 billion.
As Pete Davis notes:
GAO notes the complicated role played by the federal government, which guaranteed those pensions and now owns GM and Chrysler. GM and Chrysler bought union peace by overpromising pension benefits, knowing that the taxpayers stood behind those promises. Now what should the government do, take it out on the auto workers or hit the taxpayers to benefit the auto workers? Your elected officials will have little difficulty making this decision, invariably hitting future taxpayers to benefit favored constituents, like the auto workers.
Too true, but how likely is that? There are a lot of scary big numbers floating around about the potential unfunded liabilities of the Pension Benefit Guarantee Corp., which guarantees private sector pensions. They are indeed huge, and I think it more likely than not that the PBGC will eventually need a bailout. But not for the total amount of its potential unfunded liabilities; many of those companies will keep operating.
So the important question is, will GM be among the problem children who actually dumps its pension obligations on the taxpayer? As luck would have it, GM's numbers are just out, and . . . um . . . they're losing a lot less money than they used to!!! Only $4.3 billion since they emerged from bankruptcy. And the CEO says they might even make a profit in the near future, maybe.
To be fair, that includes whopping dose of one-time charge. On the other hand, there's a lot of grim news lurking deeper in the reports, according to The Truth About Cars:
Of course, you have to dig into the numbers to find the bad news, like the $56.4b in "cost of sales," or the $700m interest cost, or the 48 percent North American capacity utilization in 2009, or the 16.3 percent US car market share.
Make no mistake, these companies are still on life support. The CBO expects that the lion's share of the government's losses on TARP will come, not from anything the Bush administration did, but from the Obama administration's decision to bail out the automakers and to a lesser extent, its bailout of homeowners. It seems that a big chunk of our cost may come from picking up the gold plated pensions . . . "Cadillac Plans", if you will . . . of the automakers. And lest you think I'm picking on unions over management, it was management that used the UAW as a prop to extract these gargantuan sums from the pockets of innocent taxpayers.
I feel like we ought to get a little something back, here. At the very least, they could offer everyone in America that OnStar service that sounds so great in the commercials.
China records rare $7.2 billion trade deficit
by Patti Waldmeir and Jamil Anderlini
China on Saturday announced a rare deficit in its politically sensitive trade balance for March, the first in six years, bolstering Beijing’s argument that the value of its currency only has a limited impact on international trade flows.
News of the $7.2bn deficit comes at a fortuitous time for Beijing, which is under pressure particularly from the US to allow the renminbi to appreciate – a move which would make American exports to China relatively cheaper. Timothy Geithner, US Treasury secretary, this week made an unscheduled visit to Beijing for talks with Wang Qishan, the Chinese vice-premier responsible for economic affairs, as the US Congress has been putting pressure on the White House to force a change in China’s currency regime. Hu Jintao, the Chinese president, is also likely to discuss the renminbi with Barack Obama when he flies to Washington for nuclear talks on Monday.
The trade gap was mostly due to strong imports of oil, raw materials and cars, the General Administration of Customs said on Saturday. Chen Deming, China’s commerce minister, said in recorded comments broadcast on state television that he expected the deficit to be temporary. It reflected China’s openness to other economies and was not linked to exchange-rate levels, he added. The deficit supports arguments often made by Chinese officials and analysts who say the level of the renminbi is not the most important factor influencing China’s trade surplus and other countries’ deficits. They point to the fact that a 21 per cent rise in the renminbi against the dollar between 2005 and 2008 was accompanied by a soaring Chinese trade surplus.
However, economists pointed out that the March data were not likely to significantly delay any decision by Beijing to allow the currency to appreciate, although they could undermine the near-term case for renminbi appreciation. Saturday’s announcement suggested that trade flows were adjusting even though the dollar exchange rate had been stable since the middle of 2008, said Nigel Rendell of RBC Capital Markets. “We believe ... that the significance of such an outcome is somewhat overstated, given that it is normal for China’s monthly trade balance to be lower in the first quarter of the year,” he said.
”For the whole year we still expect a trade surplus. How big it is depends on how fast the economy grows and what happens with commodity prices and import volumes,” Guo Shuqing, chairman of China Construction Bank and former head of the State Administration of Foreign Exchange, said before the data were released. He said the expected monthly deficit was largely due to seasonal factors in the wake of the Chinese new year holiday in February and stockpiling by Chinese companies.
The month following Chinese new year, which fell in February this year, is usually characterised by a significant narrowing in the trade surplus, says Jing Ulrich, head of China equities and commodities at JP Morgan. “This is primarily due to Chinese manufacturers ‘front-loading’ ... production and shipments ahead of the holiday season, in order to ensure that orders scheduled after the holiday can be met on time,” she added.
China Inflation Seen at 15% With Wen Jiabao Losing Boom Control
by Kevin Hamlin
“Look at the scale of this,” said Li Chongyi, an engineer, as he watched a 4-kilometer line of trucks and earth movers busy quadrupling the size of Chongqing’s Jiangbei International Airport. “This will take years.” Jiangbei, which begins work on a third terminal when the second is done next year, is one of 15 trillion yuan ($2.2 trillion) in projects begun in 2009, almost twice the economy of India. Most were started by local governments as China’s stimulus package sparked a record 9.6 trillion yuan of loans.
The projects and their loans are stymieing efforts by Premier Wen Jiabao to curtail investment as inflation rose to 2.7 percent in February, a 16-month high. Failure to rein in local government spending could push inflation to 15 percent by 2012, said Victor Shih, a political economist at Northwestern University who spent months tallying government borrowing. “Increasingly the choice facing the government is between inflation or bad loans,” said Shih, author of the book “Finance and Factions in China,” who teaches political science at the university in Evanston, Illinois. “The only mechanism for controlling inflation in China is credit restriction, but if they use that, this show is over -- a gigantic wave of bad loans will appear on banks’ balance sheets.”
Attempts to curb borrowing by raising interest rates would boost debt-servicing costs for local governments. At the same time, tightening credit may stall projects, triggering “a build-up of bad loans,” the Basel, Switzerland-based Bank for International Settlements said in a quarterly report in December. Nomura Holdings Inc., Japan’s biggest brokerage, estimates local government projects started last year totaled up to 10 trillion yuan -- 2.5 times the official 4 trillion yuan stimulus plan. The Chongqing Economic Times reported April 6 that the city plans to spend 1 trillion yuan on another 323 projects.
Construction companies working on projects begun by provincial governments may be shielded from a wider slowdown in China’s property market, said Ephraim Fields, a fund manager with Echo Lake Capital in New York. “These vital, long-term projects should get the necessary funding even if the overall economy slows down a bit,” said Fields, who holds shares of China Advanced Construction Materials Group Inc., a Nasdaq-listed concrete maker that gets more than 75 percent of its sales from government infrastructure projects.
Roth Capital Partners also favors Beijing-based CADC. The company’s stock may rise 52 percent to $8 within a year, the Newport Beach, California-based fund manager forecast. BOC International analyst Patrick Li recommends buying Xinjiang Tianshan Cement Co., which he forecasts may gain more than 15 percent, and Tangshan Jidong Cement Co., which may rise almost 23 percent. The projects begun in 2009 will help China’s cement output rise 11 percent, or 186 million tons, this year, Li predicts.
Chongqing, China’s wartime capital on the Yangtze River, is a prime example of how provincial governments multiplied the effect of the central government’s stimulus plan. The city had 900 billion yuan in loans and credit lines outstanding at the end of 2009, said Northwestern’s Shih. Chongqing’s economy expanded 14.9 percent last year, with investment in factories and property expanding the most in 13 years. “Chongqing really stood out,” said Hong Kong-born Shih, 35, who joined Northwestern in 2003 after completing a PhD in government at Harvard University.
Chongqing’s projects include a light rail system that will receive more than 10 billion yuan in investment this year. The city will spend at least 8 billion yuan on rail construction and another 15.5 billion yuan on 288 kilometers (179 miles) of new expressways. Jiangbei airport said it plans to raise passenger capacity to an annual 30 million when Phase II is completed next year, from 14 million in 2009. Phase III, would raise throughput to 55 million passengers.
The municipality’s construction boom has boosted business confidence and the property market, said Bruce Yang, managing director of Australia Eastern Elevators Group (China). Sales at Eastern Elevators surged 51 percent in 2009, aided by projects such as a local-government office block in Nan’an district that needed 20 elevators, Yang said at the company’s headquarters in Nan’an. He has an order this year to install 23 lifts in a government-sponsored hospital near Chengdu in Sichuan province.
Chongqing isn’t alone. Sun Mingchun, an economist with Nomura in Hong Kong, estimates local governments have proposed projects with a value of more than 20 trillion yuan since the stimulus package was announced in November 2008. They include high-speed rail links between Wuhan in central China and Guangzhou in the south, the Hong Kong-Macao-Zhuhai Bridge, and the construction or upgrading of 35 airports. The economic planning agency says 5,557 kilometers of railways and 98,000 kilometers of highways opened last year.
The building boom boosted construction and materials stocks, raising concerns of a bubble. Baoshan Iron & Steel Co. rose almost 74 percent since the stimulus was announced while Anhui Conch Cement Co. gained 135 percent. The Shanghai Composite Index rose 80 percent in the period. Construction of high-speed rail lines linking Xi’an with Ankang and Datong in Shaanxi province have pushed CADC’s output to capacity, President Jeremy Goodwin said in a phone interview. “The demand is so great we are struggling to keep up,” said Goodwin.
Should the boom end in a property-market collapse, even those stocks tied to the local government projects will be affected along with most other industries, said Shanghai-based independent economist Andy Xie, formerly Morgan Stanley’s chief Asia economist. “Corporate profits are very much driven by the property sector,” said Xie. “The largest sectors will be hit hard, especially banks and insurance companies.”
A gauge of property stocks has fallen more than 6 percent this year after more than doubling in 2009 as the government takes steps to cool rising prices, including raising the deposit requirement to 20 percent of the minimum price of auctioned land. Property sales were equivalent to 13 percent of gross domestic product last year. “Policy makers may need to start thinking about how to handle the aftermath of the bust,” said Nomura’s Sun.
Policy makers have also moved to tighten credit. The central bank is seeking to slow lending growth by 22 percent to 7.5 trillion this year. China’s local governments set up investment vehicles to circumvent regulations that prevent them borrowing directly. These vehicles borrow money against the land injected into them and guarantees by local governments, said Shih. Chinese officials have pledged to limit the risks posed by these vehicles. China plans to nullify guarantees provided by local governments for some loans, said Yan Qingmin, head of the banking regulator’s Shanghai branch, March 5.
The World Bank said on March 17 that China, the world’s third-biggest economy, needs to raise interest rates to help contain the risk of a property bubble and allow a stronger yuan to damp inflation. “Massive monetary stimulus” risks triggering large asset- price increases, a housing bubble, and bad debts, from financing local-government projects, the Washington-based World Bank said in its quarterly report on China. The World Bank raised its economic growth forecast for China this year to 9.5 percent from 9 percent in January.
The financial burden of those measures on local governments means that “loose liquidity conditions” will persist for longer than they should, said Shen Minggao, a Citigroup Inc. economist in Hong Kong. Any effort to quickly exit stimulus policies would lead to “an immediate increase in non-performing loans in the banking sector,” he said. “To avoid a credit crisis, Chinese authorities may have to delay a policy exit in the hope that time remedies the pain.”
Who Will Pay for China’s Bad Loans?
by Michael Pettis
Since this is a very long post, it may make sense first to provide a quick summary of what I am going to argue. As I have discussed often in earlier posts, pessimists are starting to worry about excessive debt levels in China, about which they are very right to worry, and many are predicting a banking or financial collapse, which I think is much less likely. Optimists, on the other hand, are blithely discounting the problem of rising NPLs and insisting that they create little risk to Chinese growth. Their proof? A decade ago China had a huge surge in NPLs, the cleaning up of which was to cost China 40% of GDP and a possible banking collapse, and yet nothing happened. The doomsayers were wrong, the last banking crisis was easily managed, and Chinese growth surged.
But although I think the pessimists are wrong to expect a banking collapse, the optimists are nonetheless very mistaken, largely because they implicitly assumed away the cost of the bank recapitalization. In fact China paid a very high price for its banking crisis. The cost didn’t come in the form of a banking collapse but rather in the form of a collapse in consumption as households were forced to pay for the enormous cleanup bill.
When US leverage was rising and the world growing quickly, the cost of that collapse in consumption was easily masked by China’s surging trade surplus, but it was real nonetheless. The bank recapitalization resulted in a brutal exacerbation of China’s already unbalanced growth model, and made it all the more vital for consumption in China to surge, especially as the world’s appetite for Chinese trade surpluses is dwindling rapidly. As happened in Japan after 1990, when households were forced to clean up their own massively insolvnet banks, the consequence could be a slowdown in consumption growth just as the country is being forced to rebalance its economy towards consumption.
If there is another surge in NPLs and government debt, once again the banks will need to be recapitalized, but the cost this time will be much more difficult to manage. If NPLs surge, in other words, don’t expect a banking collapse. Expect further downward pressure on consumption growth.
Since 2004-5, I have been arguing that the Chinese national balance sheet includes a lot more debt than most analysts realize, and that it is structured in a way that I defined as “inverted” in my book, The Volatility Machine. Among other things, inverted debt structures tend to result in a surge in debt at the worst possible time, when the economy is already struggling, usually through an explosion in contingent liabilities.
This means that even if countries with inverted balance sheets don’t currently have very high debt levels, in many cases they should nonetheless be considered and analyzed as highly leveraged because at exactly the time when leverage becomes a worry, debt levels will automatically rise. This is why I have argued (predicted?) for the past five years that “within a few months” the market was going to become obsessed with China’s debt structure.
Unless you define a “few” months as forty to sixty months, clearly I have been wrong for many years – calling things way too early is perhaps an occupational hazard for those who read too much financial history – but it seems that debt levels are finally becoming an issue. In the past six months the market has become much more passionate about figuring out what China’s debt structure really looks like, and much more worried with what it sees.There is widespread recognition that Beijing’s total debt is not the 20-25% officially recorded, but a lot higher.
In fact going through my calculations I think it is hard to come up with a number less than 60-70% of GDP, perhaps much more, and this is almost certain to rise sharply in the next few years. And there may be stuff out there that I haven’t even considered: For example just how much bad debt is there in the SOEs? Are all current non-performing loans in the banking system correctly identified? How sensitive are NPLs to rising interest rates, or to a rising RMB? Is the PBoC currently solvent, and what would be the impact on net indebtedness of a currency revaluation? Is there municipal and provincial indebtedness that has not been captured in the visible debt, including the guaranteed funding vehicles that Victor Shih famously identified? How much bank debt is collateralized by potentially overvalued real estate? I could go on.
But although there are definitely things to worry about when we examine China’s balance sheet, I wonder if now the worriers, after ignoring the problem for so long, may not be getting a little overexcited about the consequences, or at least about the wrong consequences. Beijing definitely has a lot of debt, and much of it inverted and so highly pro-cyclical, and normally this is a toxic combination, but there are also some stabilizing factors within the country’s balance sheet that are being ignored. A number of very smart people are now warning that China is on the verge of a banking or financial collapse, but I don’t think this is likely.
Rising NPLs? No problem
Let me quickly insist that I am not in those camps that argue that the problem is much less severe than we think, or that China can costlessly grow its way out of the debt as easily in the future as it has in the past. This last point is one that is made very often, I think, by the more optimistic of China analysts,who have pointed out perhaps too many times that the last surge in non-performing loans a decade ago was also widely cited by doomsters as a sign of impending collapse. And yet, they cheerfully claim, nothing terrible happened – China grew its way out of the loan mess at little apparent cost, and it can do so again.
Even The Economist, a lot more skeptcial about miracle cures when it discusses other countries, takes the view that China’s last banking crisis was relatively painless. They also have been resistant to claims that debt levels are much higher than reported, and recently approvingly quoted one analyst as saying that the very worst-case scenario was debt levels of less than 40-50% of GDP (with which I strongly disagree). In fact I was reading an issue from, I think January, in which, after expressing a great deal of doubt in one article about the higher debt numbers some analysts were proposing for China, just a few pages later, in an article about bad debt in the US, approvingly quoted Carmen Rheinhart (co-author of This Times is Different) as saying that contingent debt levels almost always turn out to be worse than even the pessimists expected. Their skepticism is pretty variable, I guess.
But while there is certainly a legitimate and intelligent debate about how much Chinese government and bank debt there really is, the commonly-repeated argument – that high debt levels don’t matter and the doomsayers are wrong to worry because they were wrong in the past – does not qualify, for me anyway, as a very plausible argument. I think anyone who makes this claim has failed to understand how Beijing paid for its earlier banking crises. In fact the cost of resolving the previous surges in non-performing loans actually exacerbated China’s domestic imbalances and left China in a perilous position, and the current build-up of bad debt may very well do more of the same.
How so? The first and most obvious point to make is that if a highly insolvent banking system is cleaned up, you cannot simply assume away the cost without identifying who actually paid for it. Here is where the confusion resides. The optimists perhaps assume that the only way that a banking crisis gets resolved is through a banking collapse or an explicit bailout. Since there was no banking collapse in China in the past decade, and what looked like a fairly small and manageable bailout, then clearly there was no real banking crisis, right?
Not necessarily. There are many ways to resolve banking crises, some more visibly and some less so – just no way to resolve them costlessly, and the key is to figure out the true cost and how it was paid. As I see it there were mainly three sets of tools Beijing used to manage the sharp increases in bad loans that threatened the banking system a decade ago, and of the three, the two most important were not explicit and so not easily measured or noticed. All of these required forcing down interest rates so as to pass the bulk of the cost onto bank depositors, and so all of these had an adverse impact on the quality of Chinese growth. In other words the previous cost of the banking crisis was not a banking collapse, but that doesn’t mean the cost was easy to absorb.
The role of interest rates
The first of the three tools used to manage the banking crisis involved reducing the accumulation rate of NPLs, basically by keeping borrowing rates low. The PBoC actually has been explicit about this policy. Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments. This slows the growth of NPLs by passing on part of the cost to someone else.
Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount, but this forgiveness is effectively disguised. Those who remember the Brady debt restructurings of the 1990s fully understand how this works. In the main Brady restructurings, creditors were offered equivalent exchanges in which either principle was explicitly forgiven (the so-called Discount Bonds) or, alternatively, for those who found it difficult to recognize or acknowledge the principle discount, coupons were set at very low fixed rates (the Par Bonds). Similarly, by repressing interest rates, the PBoC was able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers.
But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did. The PBoC repressed both lending rates and deposit rates to allow struggling borrowers debt forgiveness and some breathing space. Of course households paid for this in the form of very low returns on their savings (and with few alternative investment opportunities, they had no choice but to accept the cost).
The second of the three sets of policy tools, and the only veryexplicit one, involved infusing the banks with additional equity. Part of this occurred directly with the sale of bank equity to government institutions, and part of this capital infusion occurred indirectly by creating AMCs to purchase bad loans at well above their liquidation value. In both cases the capital infusion was financed by government borrowing, which at artificially low rates, to repeat what I said above, has the effect of passing the repayment burden onto lenders. Since most of these bonds were held by banks, once again the cost of the capital infusion was passed on through the banks to depositors. (As an aside, because equity infusions were so explicit, and because the banks are no longer fully owned by the government and are even partly owned by foreigners, I suspect future recourse to this particular form of recapitalization may be limited.)
Finally and most importantly, the third way of cleaning up the banking crisis involved the central bank mandating a wide spread – probably around 1.5 to 2.5 percentage points more than the normal spread – between the bank lending and the deposit rate, which increased bank profitability substantially and so helped to recapitalize the banks. In other words not only were depositors “taxed” for the clean-up by having to fund the very low lending rates, but they were taxed a second time to guarantee sufficient bank profitability to rebuild capital. With all these transfers from the household sector to the banks, amounting to several percentage points of GDP every year, households were forced to clean up the Chinese banking system.
Beijing’s strategy to clean up the banks was very successful, and certainly prevented the banking crisis that many expected, but there was nonetheless a significant cost to the economy. The bailout implicitly required that bank depositors subsidize the cleaning up of the banking industry. This in effect represented a large transfer of income from the household sector to the banks, to government and to businesses, equal annually to several percentage points .
NPLs and household consumption
How much was the value of the transfer? It’s hard to say, but we can make some estimates. Over the past decade nominal lending rates in China have been about 6% while nominal GDP growth rates have been 14%. Economic theory tells us that nominal interest rates should be equally to nominal GDP growth rates if providers of capital are to earn their fair share of growth, and in fact in developed countries the relationship holds pretty well. Jonathan Anderson at UBS put together a very interesting analysis in a November 12, 2009, report that argued that it was wrong to assume Chinese nomnal interest rats should be equal to its nominal growth rate. He looked at the case of other developing countries and found that there was no obvious relationship between the two.
But I am not convinced. First off, if nominal interest rates are much lower than nominal growth rates, then almost by definition the providers of capital are getting less than their share of the benefits. Since the providers in China are mainly households, and the users of capital are businesses, speculators, and the government, this must represent a real transfer of wealth from households – which I think Anderson acknowledges, although he argues that the high savings rate is an independent variable that drives the low interest rate, whereas I think that it is one of the consequences of low interest rates and other policies that force households to subsidize production (and so force up the gap between production and consumption, which is the savings rates).
Secondly, his sample includes a lot of developing countries with closed or sticky capital accounts, or who intervene in their currencies, most especially the countries that followed the so-called Asian development model. These countries have systematically repressed interest rates – in fact that is for me one of the definitions of the Asian development model. This makes their inclusion in a statistical sample to determine the “correct” level of interest rates very questionable. He also includes a lot of OPEC countries who for totally different, and explainable, reasons have very low interest rates, and these too create a downward bias in the statistical sample.
Finally from his own numbers, even with the possibility of significant statistical bias, I would say that there does seem to be a reasonable relationship between nominal interest rates and nominal growth rates. On average nominal interest rates have been roughly two-thirds of nominal growth rates, although there is wide dispersion around the mean, s we would expect if interest rates were repressed.
This is not a very scientific way of going about it, but my very back-of-the-envelope estimate suggests that interest rates in China, without financial repression, should have been anywhere from 300 to 800 basis points lower than some appropriate equilibrium level during the past decade. Add this to the excess spread between deposit and lending rates, which is anywhere from 150 to 250 basis points, and we could easily argue that the deposit rate is at least 450 basis point lower than it should be, and perhaps an awful lot more.
How much is that in GDP terms? A quick call to my friend Logan Wright at Medley Advisors gave me the following data. Total banking deposits in China are around RMB 64 trillion. Around 60% of the total represent household deposits (an estimate, since there is some ambiguity in the numbers). Total GDP is nearly RMB 34 trillion. Inputting all of that into my trusty Excel Spreadsheet suggests that at a minimum, households have “paid” in form of excessively low rates on their deposits a minimum of 5% of GDP every year, and possibly up to two times that amount, during the past decade.
This is, to me, an astonishing number. Every year households may have transferred at least 5% of GDP to the banks, and possibly a lot more. Now of course they are paying for a lot more than simply cleaning up the banks. They are also paying to keep the cost of capital low so as to make viable a whole series of investments – manufacturing investments, real estate investments, infrastructure investments, PBoC sterilization bills, other government bonds, etc. But since a lot of this investment occurs through the banking system anyway (for example banks buy most sterilization bills), much of this ends up as part of the bank clean-up.
By the way forcing unlucky households to clean up the banks is pretty standard in the annals of banking crises, and for example has occurred in the USwith the recent bank bailouts (which of course were paid for with taxpayer money), but not only does the total bill over many years much higher, because of its domestic distortions the impact in China was worse than it would have been in the US. Added to the other major transfers from the household sector (the undervalued exchange rate, and slow wage growth relative to productivity growth), and given the sheer size of the clean-up, it is perhaps not surprising that during the period of the bailout, household income, already a relatively low share of GDP, declined to alarming levels. This happened even in spite of explicit attempts by Beijing to raise the household consumption share of GDP.
This, then, is the real risk of another bout of rising non-performing loans in China. It is not that China’s banks are likely to collapse. It is illiquidity thatcauses bank collapses, and unless capital controls are sharply undermined we are not likely to see this happen in China. Debt levels are certainly high and highly pro-cyclical, but even if the banks are insolvent Beijing largely controls domestic funding and domestic interest rates and can protect itself from the bank runs that plagued US and European banks. We saw the same thing in Japan thirty years ago, when it was able to fund the massive banking bailout and soaring government debt levels, to what would earlier have seemed like unimaginable levels. Like Tokyo in the 1990s, Beijing is in a strong position to continue to fund its rising bank-related liabilities and will not have a debt problem any time soon. Government debt levels are indeed very high, but they can go much higher.
This doesn’t mean however that we don’t need to worry about the debt, and it certainly does not mean that if China runs up more bad loans as a consequence of the recent lending spree it will simply “grow” its way out. In the past China could certainly grow its way out, even with household consumption declining as a share of GDP, because one effect of declining relative consumption – a rising savings rate along with a rising trade surplus – was easily absorbed by a rapidly growing world economy. As long as debt levels in the US and other deficit countries could easily rise to counteract theadverse employment effect, the world, and especially the US, had no trouble with absorbing China’s rising trade surpluses.
Rebalancing household consumption
Things may be very different now. Unemployment is high in trade-deficit countries and debt levels are being forced down. If the world can no longer absorb rising trade deficits, and especially if over the next few years trade tensions increase, China must reduce its excessive reliance on exports and investment to fuel its continued growth. The only healthy way it can do so is if household consumption rises as a share of GDP.
And household consumption will indeed rise as a share of GDP – with such a low current level of household consumption, and rising global concern overthe employment effects of China’s trade surplus, China has no choice. But since growth in household consumption has always been constrained by thegrowth in household income, it may be unreasonable to expect a surge in consumption when households are also required to clean up another sharpincrease in non-performing loans.
So as a consequence of the global crisis, China’s growth will rely more than ever on the growth of household consumption. The good way this can happen is by a surge in household consumption that will allow economic growth to remain high. The bad way is by lower growth in household consumption matched by a very sharp decline in economic growth. If the worriers are right, and non-performing loans surge, China can nonetheless easily avoid a banking collapse, but that does not mean the cost of cleaning up the banks will be negligible. On the contrary, it will put even more downward pressure on low-consuming Chinese households and will make the inevitable rebalancing of China’s economy much more difficult than many expect.
As I discussed in a posting last month, Japan showed how difficult. In the past two decades Japanese consumption growth has slowed from its headier pace of the 1980s. Consumption growth has limped along at 1-2% annually from 1990 to now as Japanese households were forced indirectly to clean up their own bad loans using almost identical mechanisms – repressed interest rates and an undervalued currency. Whereas in the 1980s, when Japanese economic growth exceeded its consumption growth thanks to its large and rising trade surplus, in the past two decades Japan’s economic growth – lessthan 0.5% annually – has been less than its consumption growth as Japan slowly and painfully rebalanced its economy towards consumption.
Likewise perhaps with China. Unless the rest of the world is willing to absorb rising trade deficits and supply it with rising trade surpluses, rebalancing for China means that instead of being the lower limit of economic growth, consumption growth will now be the higher limit. If future Chinese consumption growth also slows, as it did in Japan, because households are forced to foot the new bad-debt bill, we may see the real cost of the current explosion in bad loans – several years of sub-par growth.
It turns out that banking crises might not be costless, even if they don’t lead to banking collapses. In the case of China they may instead lead to a collapse in consumption. As part of the trade dispute that China is facing with the rest of the world, this should give some indication of how little room China has for its adjustment. Anyone who is too impatient with the glacial pace of Chinese adjustment must recognize just how difficult it will be for China quickly to reorient its economy towards household consumption. The risk is that China, like Japan in the 1990s, rebalance in the form of a very sharp contraction in GDP growth as households struggle to pay for the misallocated lending boom.
The emotional markets hypothesis and Greek bonds
by Gillian Tett
When Europe plunged into its last big markets crisis, almost two decades ago, George Soros, the hedge fund investor, reputedly made $1bn cannily betting against sterling. On Friday, as the eurozone writhed amid the Greek debt trauma, Mr Soros was fighting on another front: trying to redefine economics and markets to take account of human emotions. In the genteel surroundings of the Great Hall of Kings College, Cambridge, dozens of the world’s leading economists conducted an earnest conference on the future for economics, partly funded by Soros’ $50m largesse.
One of the central conclusions of the day was that economists and market traders alike need to devote far more time to human psychology, rather than just the raw economic numbers beloved of many policy wonks. “We need to recognise that humans are partly rational and partly instinctive,” Adair Turner, head of Britain’s Financial Services Authority, solemnly declared. Or as Mr Soros echoed: “Economic phenomena have thinking participants, natural phenomena do not ... [but] participants’ thinking does not accurately represent reality.”
It is a timely lesson, given what is now happening in relation to Greece. In the past few days, the price of Greek government debt instruments has gyrated dramatically amid widespread concern about sovereign risk. Last Monday, for example, the yield on two-year Greek bonds was just over 5 per cent. By the end of the week it had risen well above 7 per cent – an extraordinarily large jump by historical standards. Meanwhile, the cost of insuring one-year Greek debt against default, using derivatives, swung between 450 basis points and 650 basis points. That leaves Greece almost in the same category as Iraq.
Some of these price gyrations can be blamed on Greek finances. As my colleague Wolfgang Münchau noted earlier this week, the Hellenic republic’s debt is now so big that it is hard to see how it will restructure itself without a default, devaluation or international rescue – and the latest data appear to be getting worse, not better. However, hard numbers do not explain all of these market swings. There is also a crucial problem of human psychology at work – albeit in a form that is perhaps more subtle than is usually recognised.
The events of the past two years have changed the way many market players assess risk. Until 2007, most professional western asset managers had built their careers in a world that seemed generally calm and predictable. To be sure, the average British, German or American fund investors might have seen some market shocks in their lives. Just think of the 2001 internet crash or 1997 Asian crisis.
But these prior shocks tended to be short-lived, relatively contained, and – crucially – did not threaten to bring down the entire system. Instead, in the decade before 2007 the macro-economic climate appeared to be so utterly benign and stable that economists dubbed it the “Great Moderation”. Investors were so confident – or complacent – that this “moderation” would last, that they kept borrowing more and more, and accepting lower returns for the same risk. “In the 1920s there was a similar pattern, [the] risk premium went down,” Jeremy Siegel, professor of finance at Wharton, observed on Friday, noting that this only makes sense if investors convince themselves that “the economy is stable”.
However, the events of the past two years have blown apart that cosy sense of complacency – and confidence. Suddenly investors have learnt, often for the first time in their lives, that the world is not always stable; scenarios that used to appear unimaginable have come to pass: the mighty Lehman Brothers failed; Iceland imploded; the entire capital markets system came to the brink of collapse. And while some of this crisis may now have passed – at least, in the sense that the largest banks have been shored up – the sense of psychological shock remains. The markets are suffering from something akin to post-traumatic stress disorder. Or as George Akerlof, the behavioural economist, observed: “In good times, people trust. But in bad times, confidence disappears and that cannot be restored.”
One practical consequence of this is that many investors now find it hard to judge the “real” riskiness of sovereign debt. Three years ago, it seemed inconceivable that a country such as Greece would be allowed to default, or exit the eurozone. But back then it seemed equally hard to imagine that Lehman Brothers might fail. Now that Lehman has gone, who knows what the worst-case scenario might be? Could the eurozone break up? Could Greece default? What might happen to other debt-laden nations, such as the US, if the worst case scenario occurred?
The one thing that is clear is that the answers to those questions now depend as much on culture and politics as on macro-economics. That in itself is apt to sow more fear, further undermining the complex computer models used by so many investors over the past decade in their efforts to divine the future. In this new world of sovereign risk, what really matters is a set of issues that cannot be plugged into a spreadsheet. The old compass no longer works.
For some investors, this brave new world is not quite such a shock; after all, as Markus Brunnermeier, a Princeton professor, pointed out on Friday, men such as Mr Soros did not make their fortunes by thinking that markets were rational. But for many ordinary investors, the extreme uncertainty is very unsettling. Stand by to see plenty more wild market swings in the weeks ahead as rational and emotional approaches collide.
Graydon Carter and Michael Lewis: The Unabridged Conversation About the Financial Collapse
by Jessica Flint
Recently Vanity Fair editor Graydon Carter and V.F. contributing editor Michael Lewis sat together onstage in front of an intimate crowd at the Museum of Modern Art in New York City and discussed Lewis’s new book, The Big Short: Inside the Doomsday Machine, which tackles the question of what caused the U.S. economy to tank. (It was excerpted in the April issue.)
Among those who attended the event were writers Tom Wolfe and Gay Talese, New York City police commissioner Ray Kelly, and Time Inc.’s John Huey. Now you too can hear the entire conversation between Carter and Lewis—just click here. But be careful visiting that link. You will probably get sucked into Lewis’s hour-long talk, just as the House Republican book group became engrossed in a lecture Lewis gave about the financial collapse.
“I was supposed to be there for an hour,” says Lewis in the clip above, referring to his visit with the Hill staffers. “I was there for almost three. And nobody left. And their questions were increasingly: ‘Oh my God, Goldman Sachs did what? A.I.G. did what?’ They didn’t understand it ... The minute they started to understand, they were outraged. And I think the more things are explained, the more outraged people will get.”