"Treasury Department, Bureau of Printing and Engraving. Destruction Committee. Maceration of old currency." The lady is Mrs. Louise Lester, "in charge of mutilation."
Ilargi: It's one thing for the US government to go after Goldman Sachs. But while Goldman's actions have been obviously fishy, whether they’re outright criminally illegal or not, and whether they involve and include activities that make the firm a de facto bookmaker, or perhaps just constitute withholding information that the law requires divulging, let's not forget it was Washington that allowed Goldman to attain bank holding company status, which enabled Blankfein et al to rape and pillage the Fed discount windows and take the zero percent cash received straight down to the race track.
And we need to wonder what the government's role here is precisely. If Goldman stands accused of betting and withholding information, how, pray tell, is that different from the White House letting Fannie Mae and Freddie Mac now underwrite 96.5% (!!) of all US mortgage loans? For one thing, this presents a far larger bet than anything Goldman Sachs could ever dream of. For another, where is the information? Or the justification for, and the reasoning behind, this multi-trillion dollar wager?
Sources like Robert Shiller and others may declare that according to their data, US home prices are not sinking like so many anvils anymore, but they don't explain why that is; they don't even try. The perceived apparent idea is that the economy is recovering. Well, excuse us, but shouldn't they maybe try to figure out where the housing market would be without the government guaranteeing just about every last penny of it? And why doesn't anyone ever question this practice? No Congressmen, no journalists, nobody, far as I see. Is the kettle too scared to stir the pot?
Fannie and Freddie (and the FHA and FHLB systems) were once conceived with the alleged goal of making homes more affordable for the poorer segments of the population. And, strike me dead if they don’t, most people still believe that’s what they do. Which is easily squashed and put to rest by the fact that Congress increased the limits on the size of loans that Fannie, Freddie and the FHA can guarantee to $729,750 in high-cost housing markets. Wherever you live, you’re neither poor nor in need of taxpayer help if you buy a home that size and that price.
Let nobody try and fool nobody else anymore. Fannie and Freddie have nothing to do with the less privileged: they are the ultimate tools for Washington to keep Wall Street alive. Not only would significantly lower home values put severe strains on the major banks' balance sheets, they would also implode and destruct what Mortgage Backed Securities and various other housing related derivatives can be put on the books for.
And if Washington keeps on refusing to do so, maybe some other party can come up with some calculations on what the cost to the taxpayer would be, now that 96.5% of mortgages are provided on that taxpayer's account, of prices going down another 10%, and another set of calculations for a 20% drop, and one for 30% (or maybe 50% would be a better, more realistic view). If a government holds the view that it can spend tax revenue at will and limitless, that same government can still be put to task for doing so largely in secret. The American people have a right to know how their money is spent, on what it is spent, and above all how much.
The government needs to explain, for instance, why it has decided to prop up home prices at levels that are far higher than what they were prior to the 2002-2007 housing boom. This is vital data, because it will, or at least may, alert enough people to the fact that domestic real estate prices have zero percent chance of staying at those levels unless taxpayer money is used into perpetuity to guarantee any and all mortgages. And once you realize how this works, it gets all the more ridiculously irritating that the likes of Goldman Sachs take the derivatives written on what the taxpayer stands behind against her will, and makes multi-billion profits on them.
In a lovely case of irony, the most lucrative policy Fannie, Freddie, the FHA and the Treasury could develop is to buy credit default swaps betting that the trillions of loans for which they use a taxpayer money guarantee will fail. And for all we know, some or all of them may well have done so already. A government betting against its own citizens, that would be rich, and still only just one notch up from Goldman using zero percent discount window taxpayer money to do the exact same thing.
In a separate case, Gretchen Morgenson gives a clear and vivid indication and example of how much the White House values its pledge of transparency:
Repaying Taxpayers With Their Own CashAs we inch closer to a clearer understanding of the products and practices that unleashed the credit crisis of 2008, it’s becoming apparent that those seeking the whole truth are still outnumbered by those aiming to obscure it. This is the case not only on Wall Street but also in Washington. Truth seekers the nation over, therefore, are indebted to Senator Charles E. Grassley, Republican of Iowa, who in recent days uncovered what he called a government-enabled “TARP money shuffle.” It relates to General Motors, which on April 21 paid the balance of its $6.7 billion loan under the Troubled Asset Relief Program.
G.M. trumpeted its escape from the program as evidence that it had turned the corner in its operations. “G.M. is able to repay the taxpayers in full, with interest, ahead of schedule, because more customers are buying vehicles like the Chevrolet Malibu and Buick LaCrosse,” boasted Edward E. Whitacre Jr., its chief executive. G.M. also crowed about its loan repayment in a national television ad and the United States Treasury also marked the moment with a press release: “We are encouraged that G.M. has repaid its debt well ahead of schedule and confident that the company is on a strong path to viability,” said Timothy F. Geithner, the Treasury secretary.
Taxpayers are naturally eager for news about bailout repayments. But what neither G.M. nor the Treasury disclosed was that the company simply used other funds held by the Treasury to pay off its original loan. Neil M. Barofsky, the inspector general overseeing the troubled asset program, revealed this detail when he spoke before the Senate Finance Committee on April 20. “So it’s good news in that they’re reducing their debt,” Mr. Barofsky said of G.M. But he went on to note that G.M. was using other taxpayer money to make the loan repayment, according to the transcript of his testimony.
Armed with this information, Mr. Grassley fired off a letter to Mr. Geithner on April 22, asking for details of the transaction. “I am concerned ... that this announcement is not what it seems,” he wrote. “In fact, it appears to be nothing more than an elaborate TARP money shuffle.” Mr. Grassley heard back from the Treasury last Tuesday. Herbert M. Allison Jr., assistant secretary for financial stability, confirmed that the money G.M. used to repay its bailout loan had come from a taxpayer-financed escrow account held for the automaker at the Treasury.
What these things point out more than anything else is that any and all news of an economic recovery is at the very least greatly exaggerated. You can't make the taxpayer richer -or less poor- by spending her own money, that much is clear. But you can make her believe she is richer simply by spinning her a nice story. She wants to believe you so badly, it doesn’t even take that much effort.
The US government and its spin doctors will be busy on another front in the days to come: the Deepwater Horizon oilspill is set to reach Florida’s Atlantic beaches within days, with no solution anywhere in sight that would stop ever more oil from spilling into the ocean. Moreover, in an exploration plan and environmental impact analysis filed with the US government in February 2009, BP's worst-case scenario -by now not appearing that far-fetched-, a full collapse of the pipe inserted into the well, involves an "uncontrolled blowout" of 6.8 million gallons per day, which appears to be at least 3 times as much as what’s been flowing out to date. We may see dying animals on our TV screens until we're immune to them.
Britain, meanwhile, has it own issues. The Tories have been advised, if they win the May 6 election, to immediately ask the IMF to audit the country's financial situation. And in an -apparently- inadvertent slip, Bank of England Governor Mervyn King has suggested that whichever party wins the election will be out or power for a generation, because the economy will force it to take austerity measures so far-reaching that people will always vote for someone who promises to not inflict such pain.
It won’t take a generation, though; the next one in power will have to do the same four years or less from today. Nor will this be limited to Britain, we’ll see it all over the western world. First a left leaning party will be replaced by a right leaning one, or the other way around. Existing parties and incumbent politicians can run out of excuses -and appeal- at an amazingly rapid clip. Then people will start looking for a third or even fourth option, one with a clean sheet and a fresh set of promises. That's how the likes of Hitler and Mussolini tend to rise to power. And that, amidst all the trials and tribulations we have yet to go through, may -please, God, hold my hand- be the biggest danger we face these days.
Ilargi: Deliberations about the future direction and expansion of the Automatic Earth are ongoing. Stoneleigh has given up her day job and will soon return here full time. We could use some help from a savvy XTML programmer to tweak the Blogspot platform, from someone who can organize all required feeds, and from someone -a lawyer?!- who can assist us with regards to acquiring 501(c) status in the US (write to TheAutomaticEarth at Gmail dot com)
In the meantime, you can all help the process along -or even speed it up- through the obvious channels: by donating to The Automatic Earth (see top of left hand column) and by visiting our advertisers, something that involves no obligations on your part but helps us greatly, and gives them a reason to continue placing their ads.
The underlying theme here is that while quite a few voices wish to make you believe that what we see around us today is a genuine economic recovery, we see instead as a very welcome additional period in which you, our readers, can prepare for the time when rosy glasses become a nuisance instead of a relief. And we intend to be here to help you do that, and in a wider and more comprehensive fashion than we have so far. It’s just that executing that takes time, and resources. Some of which are bluntly financial.
And of course, any suggestions you may have on how we might improve the site are always welcome, either through the Comments section (at the bottom of each post) or by mailing us directly at TheAutomaticEarth at Gmail dot com.
Bank of England Governor Mervyn King warns that election victor will be out of power for a generation
by Larry Elliott
Mervyn King is warning that the victor in next week's election will be forced into austerity measures that will keep the party out of power for a generation, according to the US economist David Hale. Dragging the Bank of England governor unwittingly into Britain's political battle, David Hale said he had been told by King at a private lunch about the likely fiscal pain ahead. Asked about the possible contagion from Greece's sovereign debt crisis, Hale cited the high debt levels of the major developed economies, including Britain, and then went on to comment on the British election campaign.
"I saw the governor of the Bank of England [Mervyn King] last week when I was in London and he told me whoever wins this election will be out of power for a whole generation because of how tough the fiscal austerity will have to be," Hale said in an interview on Australian TV reported by Reuters. The Bank confirmed that the governor had had a private lunch with Hale, but said it had been two months ago. It declined to comment on what had been said. King, as is customary during an election campaign, has made no public statements or speeches in order to show his political impartiality.
Earlier this year, however, he made it clear that he saw tough decisions ahead for ministers as they attempted to reduce the budget deficit amassed during Britain's deepest and longest recession since the second world war. The governor, speaking at the press conference to launch the last quarterly Inflation Report in February, said: "The need for a credible plan to ensure a substantial reduction in the fiscal deficit is now clear to everyone." King added the deficit would not be tackled without "significant fiscal consolidation".
Mervyn King: Bank rate 'will stay low for four years'
by David Smith
Mervyn King believes interest rates in Britain will stay lower for longer than the markets expect, according to private conversations he had with a senior American economist. David Hale told Australian television last week that at a private meeting the Bank of England governor had told him that the tax increases and spending cuts that would be needed would be so unpopular as to keep the party that introduced them "out of power for a whole generation".
After the meeting with King, on March 11, Hale attended a drinks party and a breakfast meeting the following morning. Both gatherings were off the record but, according to people present, he also said that King believed that to compensate for the fiscal pain ahead, the Bank would need to keep interest rates extremely low. Bank rate is at a record low of 0.5%. "The impression was that rates would stay low for the next four years," said one of those present. The Bank has confirmed that King and Hale met but refused to say what they discussed.
The Bank will make its first post-election decision on rates on May 10 and publish its quarterly inflation report two days later. It is expected to push up its inflation forecast while retaining an optimistic stance on the recovery, with growth set to rise to 3% next year. King, however, has been more downbeat on the outlook than the Bank's own forecasts imply, believing that the aftermath of the banking crisis and the need for tough measures to get the budget deficit down will hobble the economy.
In the meantime, three members of the "shadow" monetary policy committee (MPC), which meets under the auspices of the Institute of Economic Affairs, are less relaxed about the outlook and favour an immediate rise in Bank rate. Two of the three, Peter Warburton and David B Smith, favour an immediate half-point rise to 1%, while the other, Andrew Lilico, wants a quarter-point rise to 0.75%. Warburton said that it would be necessary to send an early signal to the markets that the Bank was not complacent about inflation.
All three conceded that a rate rise was unlikely in the immediate aftermath of the election but said the role of the shadow MPC was to advise, not predict. The other six members of the shadow MPC said it was too early to contemplate rate rises. Fathom Financial Consulting, which will hold its monetary policy forum on Tuesday, predicts growth of 0.8% this year, followed by only 1.6% next year.
Warning Signal on U.K. Debt?
by Mark Gongloff
Value of Default Protection Has Doubled in 2010 and Is Outpacing Spain, Italy
As investors scramble to protect themselves from the next credit flare-up in Europe, their worries are spreading to the U.K. Investors bought a net $443 million of credit-default swaps to insure against a U.K. default last week, according to data compiled by the Depository Trust and Clearing Corp., taking the total outstanding to $8.2 billion. That was easily the biggest gain among sovereign borrowers. The size of protection on the U.K. has roughly doubled since the year began, a move that far outpaces the run-up in Greek CDS last fall.
The purchases haven't yet caused the prices of U.K. swaps to spike, as in other recent credit convulsions. But the market's behavior in some ways echoes behavior that preceded credit crises in Greece and elsewhere. In comparison, insurance against a default by Portugal rose by a net $10 million last week, while insurance on Spain and Italy fell. All three of those nations are being watched as the next likely avenues of Greek credit contagion. The data suggest the U.K. could soon be a target, too.
These dollar amounts are small relative to the size of each country's bond market, which could help explain their dramatic swings. And the U.K. bond market is far larger than Greece's, diminishing the relative importance of the dollar figure. But observers say they deserve close watching as a potential sign of trouble. "You can definitely infer from this that the markets are growing more concerned about the U.K.," said Tim Backshall, chief strategist at Credit Derivatives Research.
CDS prices have in recent years become closely watched indicators of potential credit turmoil. They have also become a lightening rod for criticism from skeptics who say speculators use them to force targets into default. Supporters counter that they are useful market gauges that help investors hedge their risks. Rising CDS levels alone don't suggest that credit fears are about to grip the U.K. CDS prices have been flat for the past month and are still well below their high for the year, set in early February.
Such relative stability means there are still plenty of willing sellers of CDS protection, suggesting many investors aren't concerned about the risk of default. When there are fewer willing sellers, prices go up as demand outstrips supply. Investors may be buying CDS simply to hedge the risk of making relatively bullish bets on the U.K.—namely, buying British debt in the belief it will outperform European debt, suggests Brian Yelvington, fixed-income strategist at Knight Capital. George Soros, the billionaire hedge-fund manager who "broke" the British sterling in the 1990s, recently said he believed the U.K. may be better-equipped to handle its debt problems than the euro zone.
Nonetheless, there are some obvious reasons for investors to bet against U.K. finances, at least in the short run. For one thing, a close election has raised the possibility of a "hung" parliament, in which no party has a majority. Investors also are anxious about the exposure of already-shaky U.K. banks to Europe's debt woes. The U.K. government is struggling with high budget deficits, sluggish economic growth and a debt burden that some analysts expect to rise to 90% of gross domestic product.
The rise in British CDS protection isn't a new development, having begun in late 2009. Traders say France's Credit Agricole SA and Spain's Banco Santander SA were among the banks buying insurance on U.K. debt in late 2009 and early 2010. The banks declined to comment. Surges in CDS activity may be benign, but they often precede spikes in CDS prices, according to a recent study by Credit Market Analysis, a research firm owned by CME Group. Trading in Lehman Brothers Holdings CDS picked up noticeably about six months before Lehman CDS prices began rising, according to the study. A similar increase in interest in Greek CDS also preceded the surge in Greek CDS prices last November, but with a much shorter lead time, according to the CMA study.
CDS investors are often investors who are worried about the performance of the debt they hold. There may come a point, as in the case of Lehman Brothers and Greece, when credit anxieties reach such a pitch that willing CDS sellers become harder to find and prices jump. After that, many investors will simply sell their underlying debt, meaning they no longer have any need for CDS protection. That could help explain why Greek CDS exposure has fallen in recent weeks, while Greek bond yields have soared.
Something similar might already be happening in the U.K., albeit on a much smaller scale at this point, Backshall notes. In the past week, U.K. bond yields have widened more against relatively safe German government bonds than U.K. CDS prices have risen against German CDS prices. This underperformance of bonds against CDS, though in its early stages and not always a sign of an imminent market flare-up, is another warning indicator, says Mr. Backshall. Of potential further concern: As CDS prices and demand for coverage against losses increase, the worries that contributed to those rises are liable to lead to a weakness in sterling, as occurred with Greek CDS and the euro.
Income tax must be raised by 6% to return Britain's economy to health, NIESR warns
by Edmund Conway
The next government must raise income taxes by 6p in the pound if Britain is to be brought back to full fiscal health, according to Britain's leading independent economic authority. In a bombshell report with less than a week to go until the general election, the National Institute for Economic and Social Research (NIESR) warned that all three political parties were not ambitious enough with their plans to slash the deficit. It advised that, on top of their radical plans to slash spending and reduce the shortfall in the government accounts, the election winner should "gradually raise income tax by 6p in the pound."
The advice is unlikely to be welcomed by the parties, which have already committed to spending cuts which are as deep as any since the 1970s and, in the Tories' case, since the 1920s. However, Ray Barrell, director of macroeconomic research at NIESR, said that if they intended to bring the deficit down to levels which would leave the country equipped to deal with a "future crisis or war", much more ambitious plans would be necessary. "The crisis has made us 4pc poorer. It means we have to assume there is a problem with our spending plans. Increasing debt means we are borrowing from our children and our grandchildren. We need more spending cuts and higher taxes to bring the deficit down," he said.
The Institute for Fiscal Studies calculated earlier this week that the spending cuts planned by each political party are of a scale not witnessed for a generation, but added that so far none of the parties had provided more than one-fifth of the detail on where those cuts would fall. All of the parties intend to put more of the onus on cutting spending than raising taxes, but Mr Barrell said that the idea that this was easier or more effective was erroneous. "There is no longer any strong evidence that spending cuts are better than tax rises at bringing the deficit down," he said. He suggested that, on top of their existing plans, the parties should cut public sector wages, but added that they should slap extra tax rises on top of these. Alongside a 6p increase in income tax, the government should continue with fiscal drag, where it freezes peoples' tax free allowances despite rising wage and price inflation.
In what might be seen as a blow for both Labour and the Conservatives, Mr Barrell added that the two parties' claims to be able to save money through "efficiency gains" was disingenuous. "Efficiency savings are largely a myth. When you cut spending, people lose their jobs," he said. He also added that the Conservatives' plans to cut spending by £6bn more than Labour in the first year of their term would cost the economy "between 30,000 and 60,000 jobs – although only temporarily". NIESR said it expected the economy to grow only sluggishly for the next three years, with gross domestic product growing by 1pc this year, followed by growth of 2pc and 2.2pc in 2011 and 2012. It said it expected the Bank of England to start raising interest rates at the end of this year, although it said it would take as long as five years until they come anywhere near the levels they were before the financial crisis – at around 5pc.
U.K. Budget Cuts May Lead to Depression
by David G. Blanchflower
It was always David Cameron’s election to lose. Everything now points to a hung U.K. parliament where none of the parties gains an outright majority in the election on May 6. The Conservative Party, led by Cameron, says a coalition government would be a disaster. He’ll have another opportunity to make that case in today’s third and final televised debate. George Osborne, the Conservatives’ Treasury spokesman, said this week a hung parliament posed risks “for our economic stability” and would lead to “a paralyzed economy.”
The idea that the economy would be paralyzed if there were to be a hung parliament is codswallop. The financial markets have had time to discount such a prospect and there has been little or no response from them. The FTSE 100 Index has risen 3.6 percent this year and the pound has strengthened slightly against the U.S. dollar since the beginning of March, as the polls narrowed. Gilts show no sign of imminent collapse. Arnaud Mares, lead U.K. analyst of the ratings firm Moody’s Investors Service, indicated this week that a hung parliament didn’t have direct implications for the U.K.’s AAA rating.
The real issue that Prime Minister Gordon Brown and Liberal Democratic Party leader Nick Clegg should address in today’s debate with Cameron is the Conservative Party’s proposals to cut public spending by an additional 6 billion pounds ($9.1 billion) in 2010 in an emergency budget within 60 days of being elected. This proposal was opposed by Brown’s Labour Party, as well as the Liberal Democrats, and generated a furious letter to the Times from 77 economists arguing that it was “rash” and “destabilizing.” Their main point was that only when the recovery is well under way, would it be safe to have extra cuts in government expenditure.
Just as Bank of England Governor Mervyn King said in testimony before the Treasury Select Committee on Nov. 24 last year, the budget deficit should be reduced “at a rate that is consistent with the restoration of growth in the economy.” The U.K.’s fiscal shortfall was 11.5 percent of gross domestic product in 2009, according to the European Union’s statistics office, Eurostat. British GDP rose 0.2 percent in the first quarter from the previous three months, the Office for National Statistics said this month.
Colin Ellis, an economist at Daiwa Capital Markets in London, agrees it is too soon to cut. “Growth is the No. 1 priority right now,” he says. “The private sector hasn’t been crowded out by the public sector in this recession -- instead, the public sector has supported the economy. Wielding the ax too enthusiastically now runs the real risk of tipping the economy back into recession.” Interestingly there isn’t that much to choose between any of the three parties in terms of their fiscal projections -- all intend to hack public spending over the next parliament. Chancellor Alistair Darling even admitted that Labour’s planned cuts in public spending would be “deeper and tougher” than Prime Minister Margaret Thatcher’s in the 1980s.
None of the three parties has come clean on precisely where any cuts would fall, although the National Health Service apparently is to be ring-fenced from austerity measures. According to a report this week by the Institute for Fiscal Studies, the Conservatives would need to cut spending in real terms by almost 64 billion pounds a year from April 2011 to March 2015. The Labour Party would cut by about 51 billion pounds and the Liberal Democrats by 47 billion pounds.
The institute said the Conservatives have announced measures that would bring about 18 percent of the total cuts they need, leaving a shortfall of 52.4 billion pounds. Labour’s would bring about 13.1 percent of what it would need, leaving a gap of 44.1 billion pounds. The Liberal Democrats have gone public with policies that would bring about 25.9 percent of what they would need, leaving 34.5 billion unaccounted for.
The big issue, though, is growth projections. What if the GDP forecasts, upon which the budget cuts are based, aren’t achieved? The Treasury is forecasting growth rates of 3.25 percent next year, which simply doesn’t look likely, especially on a day when Standard & Poor’s downgraded Greek debt to junk status, lowering their rating by three levels from BBB+ to BB+. Portugal’s credit rating was also cut two grades by S&P to A-, while bond yields rose in Ireland, Spain and Italy.
Without significant GDP growth, budget cuts of the magnitude described by all three parties would push the U.K. economy into a severe and long-lasting depression and cause much higher unemployment. That would inevitably mean lots more quantitative easing. The question that needs to be asked in today’s debate is what each leader plans to do if their economic-growth projections are too high. Cuts and more cuts aren’t the answer. None of them really understands how bad things could yet become. Least of all Cameron.
David G. Blanchflower is a former member of the Bank of England’s Monetary Policy Committee and professor of economics at Dartmouth College and the University of Stirling
Debt crisis: UK banks sitting on £100bn exposure to Greece, Spain and Portugal
by Jill Treanor
Shares in UK lenders slide amid fears of renewed credit crunch but French, German and Swiss most at risk from Greek default. Fears of a fresh banking crisis stalked the markets today as the risk of Greece defaulting on its debt repayments raised concerns about the exposure of major banks to indebted countries in Europe. As analysts estimated that Britain's banks have a combined exposure of £100bn to Greece, Portugal and Spain – the three countries causing most concern on the financial markets – the Financial Services Authority was closely watching the markets and assessing exposures to the vulnerable countries. A
fter the ratings agency Standard & Poor's had downgraded Greek debtto "junk" yesterday, bank shares were knocked today but spared further falls as the downgrade of Spain's crucial credit rating came just as the stock market was closing. With UK banks standing to lose more in Spain than in Greece and Portugal, analysts said there might have been a more severe reaction if London had remained open longer today.
Analysts at Credit Suisse calculated that UK banks had £25bn of exposure to Greece and Portugal but £75bn to Spain, where the collapse in the property market has already forced banks such as Barclays to admit to bad debt problems and left Royal Bank of Scotland facing questions about its exposure. "Lloyds' exposure to the three regions is likely to be negligible, we estimate that Barclays has £40bn exposure (predominantly loans in Spain and Portugal, excluding daily positions in Barclays Capital), and RBS has around £30bn–£35bn (again predominantly Spain, although we estimate £3bn to £4bn in Portugal and Greece as well)," the Credit Suisse analysts said. Money markets, in which major banks lend to each other, also reflected the tension caused by the Greek downgrade with eurozone interbank lending rates enduring their biggest rise in nearly a year.
Much of the anxiety was targeted at French, German and Swiss banks. Howard Wheeldon, of BGC Partners, said: "If Greece defaults that means the pressure will then be felt and exerted on national banks that hold the Greek debt. That includes very many German, French and Swiss banks and it just may be that with so many banks involved one of these might just go down." At today's annual meeting, RBS's chairman, Sir Philip Hampton, played down any exposure to Greece, while Lloyds' finance director, Tim Tookey, said on Tuesday that the bank had no "material [significant] exposure".
Barclays publishes a trading update on Friday and will face questions about its exposure to the countries being downgraded. In early trading today banks were the biggest fallers, with RBS tumbling 7%, Lloyds down by 6.5% and Barclays off 4%, though they recovered much of their losses by the time market closed. Among continental European banks, analysts at Evolution calculated that Fortis, Dexia, CASA and Société Générale were most affected because of the value of their Greek debt holdings relative to their size.
According to Barclays Capital, UK banks account for only 3% of the exposure to Greek bonds, while data from the Bank for International Settlements shows that, at the end of 2009, Greece owed about $240bn (£160bn) overseas. Of this, France and Germany have the biggest exposures of $75bn and $45bn respectively. Analysts expressed concern about the problems spreading. Daragh Quinn, banks analyst at Nomura, said: "Given the scale of the debt problem facing Greece, the prospect of some kind of debt rescheduling or even default are being considered as possibilities by the market.
Sovereign risk concerns are also spreading to Portugal and Spain." Only last week the International Monetary Fund, which has been called in to help fund the Greece deficit, warned about the impact of a sovereign risk crisis. "Concerns about sovereign risks could undermine stability gains and take the credit crisis into a new phase, as nations begin to reach the limits of public-sector support for the financial system and the real economy," the IMF said.
Credit Suisse analysts pointed out that not all the problems facing the markets were negative for the banking sector. "The increase in volatility should assist revenues at the investment banks, particularly for primary dealers like Barclays," the Credit Suisse analysts said. "But there are clearly a number of important potential negatives. These include the potential for increased capital and liquidity trapping in affected sovereigns, or increased micro prudential requirements for local subsidiaries. Our bigger concern, however, is increased nervousness towards the UK," they added.
But while the timing of the downgrade of the Greek sovereign rate surprised the markets, there had been expectations for some time that the ratings agencies would eventually lose patience with the situation and take the decision to downgrade. This might have helped to cushion the markets' reaction to the situation, analysts said, and was likely to ensure that the major banks and other investors had already assessed their exposure to the Greece market before the downgrade took place.
The cost of borrowing for the Greek government briefly hit 38% in a stark illustration of the impact that a downgrade can have on the health of a nation's finances. Greece has been graded BB+ by the credit rating agency Standard & Poor's, official "junk" territory. It is now on a par with Azerbaijan, Colombia, Panama and Romania. Britain is one of 11 countries with a prized 'triple A' rating, along with Australia, Denmark, Germany, France, the United States and Luxembourg. But it is the only one of the elite to have been put on "negative watch", a warning that it might face a future downgrade. The cost of Greece borrowing on a two-year bond was as little as 1.3% in November, but has risen sharply amid fears of bankruptcy. By the end of tradingtoday, the cost had fallen back to 19%. In contrast, Britain is able to borrow on two-year bonds at a rate of 1.2%. S&P's lowest rating, CCC+, is assigned to Ecuador, which defaulted on $3.2bn of bonds last year.
Annual rise in UK house prices hit double digits
by Myra Butterworth
The annual rise in house prices hit double figures for the first time in nearly three years in April. The latest house price survey from Britain’s biggest building society showed values rising 1 per cent this month, leading to annual growth of 10.5 per cent, the first time since June 2007. It means a typical home in Britain now costs £167,802. Nationwide said the figures were helped by April 2009 being one of the weakest months for house prices during 2009. And it warned it was unlikely that annual house price inflation would remain in double digit territory during the coming months.
Martin Gahbauer, Nationwide’s chief economist, said: “Given the very strong performance of house prices from May 2009 onwards, it will take monthly increases in excess of 1 per cent for the annual rate of inflation to be maintained in double digits going forward.” The recovery in the housing market which has been seen during the past year has been largely driven by the supply of homes up for sale being unable to keep up with demand from potential buyers.
But recent reports have suggested that, while the rate at which new buyers are registering with estate agents appears to have stabilized, there has been an increase in the number of people looking to sell their home. It comes as separate research showed internet searches for “houses for sale” are up 30 per cent during the first three months of this year. But with mortgage finance being limited to those with a significant deposit and fewer people searching online for mortgages, it suggests consumers are “window shopping”, according to the findings by information group Experian.
David Smith, senior partner at estate agents Carter Jonas, said: "The property market may have edged into double digit territory but it's important to put this symbolic price point into context. The price rises of the past year have been driven primarily by a shortage of stock rather than strong demand. "They are also being supported by low interest rates, which will only remain at the current level for so long, and possibly not as long as some think given rising inflation.
“Once interest rates rise, the pace of price growth will become more subdued and there may be an adjustment in the second half of the year.” Howard Archer, an economist at Global Insight said: “While house prices have firmed anew after dipping in February, it still remains highly questionable whether they can make significant further gains over the coming months.”
Tories urged to call in IMF for audit of UK’s debts if they win election
by Ambrose Evans-Pritchard and Edmund Conway
The Conservatives have been urged to consider the "nuclear option" of calling in the International Monetary Fund to examine the full extent of Britain's debts if they win the election. The Tories should invite the IMF to provide blunt advice about how to cut the scale of the budget deficit, leaving the party able, if necessary, to row back on unaffordable promises to safeguard spending and cut taxes, according to senior bankers and economists.
Bob Janjuah, chief markets strategist at the Royal Bank of Scotland, told a group of German bankers and fund managers in Berlin that the plan would involve the IMF performing a "technical audit" of Britain's public finances, rather than lending any emergency cash to Britain, as it currently is in Greece. The Institute for Fiscal Studies warned earlier this week that the spending cuts currently planned by the Conservatives are even deeper than those initiated by the IMF in the 1970s, and could be the harshest since the Second World War. Days later Mervyn King, the Bank of England Governor, was reported to have warned that whichever party won the election would soon find itself ejected from power "for a generation" because of the scale of the spending reductions that it will have to imposed.
Speaking at a Euromoney conference Mr Janjuah said: "The reason for calling on the IMF is for an audit, not for money. They can 'kitchen sink' everything from the start and blame it all on Gordon Brown." He said that the Tories may in effect "cop a plea" on the UK's sovereign rating, taking a one-notch or even two-notch downgrade in tacit exchange from the rating agencies for a stable outlook. "Britain's debt metrics are pretty ugly when you include PFIs (Private Finance Initiatives) they have off books. We think the real figure is over 100pc of GDP already," said Mr Janjuah.
Ruth Lea, director of Global Vision, said: "Any incoming government will need all the help and support it can get from as many respected independent organisations as possible. The IMF is internationally respected. It is the obvious choice to get help from - not necessarily a loan, but support and moral backing in what is going to be an appalling situation. I was in the Treasury in the 1970s. It cannot be overestimated how dreadful the situation can be when the Government has to sort out finances that are running out of control."
The plans were under examination by senior Tories some months ago, but are understood to have been dropped after the Shadow Chancellor, George Osborne, proposed creating an independent Office of Budget Responsibility to audit the public finances and suggest the scale of fiscal tightening. The OBR will be chaired by leading economist Sir Alan Budd.
French Banks Credit Agricole, SocGen Face Greek Risks as Debt Crisis Deepens
by Niklas Magnusson and Fabio Benedetti-Valentini
Credit Agricole SA and Societe Generale SA may be among European banks with the most at risk from the Greek crisis because of unprofitable units in the country. French banks have the biggest exposure to Greece among European lenders, accounting for $78.8 billion of the $193.1 billion of total claims European banks have on Greece, according to the Bank for International Settlements. They also have the second-largest claims on Portugal and Spain, after German banks, and are the biggest holders of Italian debt, BIS figures show.
Bond prices from Italy to Ireland slumped after Standard & Poor’s cut Greece’s credit rating below investment grade on April 27 and lowered Portugal as well. A day later the rating company downgraded Spain’s debt. Contagion from the Greek crisis is “threatening the stability of the financial system” like the Ebola virus, Organization for Economic Cooperation and Development Secretary General Angel Gurria said. Credit Agricole’s Emporiki Bank of Greece SA has 1.4 million clients and 22.7 billion euros ($30 billion) of loans. The French bank’s main risk in Greece comes from possible loan losses as the economy shrinks, said Jaap Meijer, an analyst at Evolution Securities Ltd. in London.
Paris-based Credit Agricole also has stakes in Banco Espirito Santo SA, Portugal’s biggest publicly traded bank by market value, and in Spain’s Bankinter SA. “The main French banks have direct exposures on Greek sovereign debt and Credit Agricole has the biggest exposure all in all, when including possible losses on its domestic loan book,” Meijer estimated. He and other analysts said a lack of precise data from banks makes it hard to pinpoint who holds what. For a table of European financial institutions’ stated exposure to Greece and Portugal, click here. The figures were provided to Bloomberg News in interviews and e-mails, or culled from company reports and presentations.
Credit Agricole, France’s biggest bank by branches, said yesterday it has 850 million euros at risk from Greek government debt, including 600 million euros at Emporiki. A company spokeswoman declined to provide further detail. Societe Generale, France’s No. 2 bank by market value, owns 54 percent of Greece’s Geniki Bank SA, which has 4 billion euros of loans and advances, according to the Athens-based lender’s Web site. Geniki’s customer deposits stood at 2.7 billion euros at the end of 2009. A Societe Generale spokeswoman declined to comment on the bank’s risks in Greece.
Banks in Greece face worsening asset quality, pressure on profitability, negative lending growth and rising loan losses as the economy contracts and the state tries to curb the country’s budget deficit. Geniki has made losses every year since 2003, while Emporiki’s 2009 net loss widened to 583 million euros. Financial shares tumbled in European trading yesterday, pushing the 52-company Bloomberg Europe Banks and Financial Services Index down 1.2 percent, on concern the Greek debt crisis will spread. Portugal’s Banco BPI SA slumped 8.3 percent. Credit Agricole dropped 3.4 percent, bringing its decline since the start of this week to 10 percent.
Fortis, the owner of Belgium’s biggest life insurer, lost 7.4 percent. The insurer, based in Brussels and the Dutch city of Utrecht, had holdings of Greek and Portuguese government bonds totaling 7.2 billion euros at the end of last year, according to a March 10 presentation. The cost of insuring against a default on government bonds of Greece, Portugal and Spain rose to records on April 28. BNP Paribas SA, France’s biggest bank by assets, has “negligible” risks tied to Greek banks, Chief Executive Officer Baudouin Prot told French radio BFM yesterday. Natixis SA, based in Paris, also said it has “negligible” risk tied to Greek government debt and “insignificant” exposure to Portugal. Banks have more at risk in Portugal and Spain than Greece.
Claims on Portugal by European lenders amount to $240.5 billion, including $47.4 billion by German banks and $44.9 billion by French firms, according to BIS figures from the end of 2009. European banking claims on Spain stand at $832.3 billion, with German financial institutions accounting for $238 billion and French companies $211.2 billion. Commerzbank AG holds 3.1 billion euros in Greek sovereign debt, while Deutsche Postbank AG owns 1.3 billion euros of Hellenic government instruments. Hypo Real Estate AG, the German lender taken over by the state following the credit crunch, has 7.9 billion euros in Greek government bonds and 1.7 billion euros in Portuguese state debt, according to a March presentation on the company’s Web site.
Dangers loom beyond the eurozone
by Chris Giles
The crisis in Greece serves as a warning to other countries not to lose control of their fiscal positions and the confidence of markets. But advanced countries have now stretched their public budgets so far that investors, economists and international organisations are getting worried. Returning to form, the International Monetary Fund warned this month that reducing budget deficits, “should precede the normalisation of monetary policy” in many economies and that they “need to make more progress in developing and communicating credible medium term fiscal adjustment strategies”.
Willem Buiter, chief economist of Citi, uses rather blunter language. “Today’s ‘best of breed’ may be the same dog that yesterday was fit only for the World’s Ugliest Dog Contest – an indicator of just how far the fiscal conditions in most advanced industrial countries have deteriorated,” he says. The problem is simple. Huge budget deficits resulting from the financial crisis have put public debt on an unsustainable trajectory and doubts are growing that the political will exists for the nasty medicine to be swallowed.
Top of the list of countries in investors’ line of fire are the other peripheral eurozone countries with weak budgetary positions – Portugal, Spain, Ireland, Belgium and Italy. Standard & Poor’s, the credit rating agency, downgraded Portugal’s sovereign debt on Tuesday, arguing that economic growth is likely to be lower in the country and fiscal consolidation slower. Portuguese officials are determined to demonstrate their intention to get borrowing under control and expect to be able to surprise markets with better-than-expected growth and deficit figures in the weeks ahead. But they also recognise the current pressures from markets pose a real danger to the sustainability of their plans. Ten-year interest rates on Portugal’s debts have risen from just over 4 per cent at the start of April to 6.3 per cent on Wednesday.
So far, investors have concentrated their ire on peripheral eurozone economies because of the single currency area’s inability to resolve the Greek crisis cleanly. That is understandable, according to many economists, but they add that the single focus on continental Europe is unfair. David Mackie of JPMorgan, for example, argues that the combined eurozone deficit and debt compared favourably with other countries. “In our view, the euro area has the fiscal capacity to backstop banks across the region and to support the sovereign states of Greece, Spain, Portugal and Ireland, along with some help from the IMF.”
This message has been picked up by eurozone policy makers. Jürgen Stark, executive board member of the European Central Bank, said on Wednesday that restoring sustainability to the public finances was “even harder for the UK, the US and Japan”. “Given their high budget deficits and the high and rising debt levels, they must undertake very strong consolidation efforts to manage a reversal.” Mr Stark’s analysis is not merely an attempt to divert attention from the eurozone. It is identical to that of the IMF.
The Fund has calculated that almost all advanced economies need to tighten fiscal policy significantly in the coming decade in order to stabilise debt at 60 per cent of national income by 2030 and the tightening needed in the US, Japan and the UK is just as bad as that required in Greece, Spain, Ireland and Portugal. The US must tighten fiscal policy by 9 per cent of national income to achieve a stable position, the Fund estimates for example, something Mr Buiter believes its politics will make very difficult. “The way things are now, the Republicans will veto all tax increases and the Democrats all public spending cuts,” he says.
This week, a survey of former senior US economic officials, unanimously agreed the US was on an unsustainable path and warned that there would be another economic crisis in the US unless the deficit was addressed. Peter G. Peterson, chairman of the non-partisan Peterson Foundation said: “It is significant to see such an overwhelming proportion of these former senior officials, Republicans and Democrats alike, agree that we must address our long-term structural deficits to avoid another economic crisis, and that we must do so now.” In the UK, the independent Institute for Fiscal Studies slammed the posturing of all parties in the election campaign, calculating that none had outlined more than a quarter of the public spending cuts they had signed up to.
And in Japan, Fitch, the credit ratings agency, warned that “in the absence of sustained economic recovery and fiscal consolidation, government debt will continue to rise, placing downwards pressure on sovereign credit and ratings over the medium term”. The difficulty for governments is that loading deficit reduction on to still fragile economies in the coming decade of ageing and increased demand for public services rarely brings popularity. This week Greece has shown that there might not be any alternative.
U.S. Role in Mortgage Market Grows Even Larger
by Nick Timiraos
The U.S. government's massive share of the nation's mortgage market grew even larger during the first quarter. Government-related entities backed 96.5% of all home loans during the first quarter, up from 90% in 2009, according to Inside Mortgage Finance. The increase was driven by a jump in the share of loans backed by Fannie Mae and Freddie Mac, the government-owned housing-finance giants.
By providing a steady source of liquidity to the mortgage market, the government has helped housing markets to stabilize. However, "Fannie and Freddie have to get smaller and less relevant in order to revamp them, and instead, every day they're getting bigger and bigger and bigger," said Paul Bossidy, chief executive of Clayton Holdings LLC, a mortgage analytics firm. The collapse of the mortgage market in 2007 steered more business to the Federal Housing Administration, which insures loans, and Fannie and Freddie, which were taken over by the government in 2008 as rising losses wiped out thin capital reserves.
Congress also increased the limits on the size of loans that Fannie, Freddie and the FHA can guarantee, raising the ceiling to as high as $729,750 in high-cost housing markets such as New York and California. Over the past year, rates on those "conforming-jumbo" loans have improved, and more banks have stepped up their offerings, helping to boost the government's already hefty share of the mortgage market, said Guy Cecala, publisher of Inside Mortgage Finance. By the end of 2009, the share of jumbo loans that were sold or backed by government entities exceeded the non-government jumbo share of the market.
Some big banks say they are beginning to increase their holdings of jumbo mortgages that are too large for government backing on their balance sheets. And last month, Redwood Trust Inc. said it planned to issue around $222 million in bonds backed by jumbo mortgage loans made by a unit of Citigroup Inc., the first such issue of private-label securities in nearly two years. Sanjiv Das, chief executive of Citigroup's mortgage-lending unit, said he expected the government's share of the mortgage market to change "substantially" over the next year. "A year from now, I wouldn't be surprised if that number is eight out of 10, as opposed to 9.5 out of 10," he said. Reducing the government loan limits, he said, would drop the government's share of the market even more.
Meanwhile, Freddie Mac on Friday said that the number of mortgages that were 90 days or more past due fell to 4.13% in March from 4.2% in February, the first monthly decline in three years. But analysts aren't ready to declare victory yet. "We're certainly going to reach a point of stability this year, but it's going to be stabilizing at these very high levels," said Ted Jadlos, president of LPS Applied Analytics, a real-estate research firm. The backlog of delinquent loans in some stage of foreclosure will keep pressure on housing markets and could take two to four years to clear, he said.
Fannie Mae Tightens Lending Standards
by Nick Timiraos
Fannie Mae on Friday said it will tighten lending standards on adjustable-rate mortgages and "interest-only" loans that helped fuel the housing bubble and have led to a disproportionate share of losses for the mortgage-finance giant. The changes, which will take effect in September, will require lenders to qualify borrowers based on whether or not they can afford potentially higher payments once adjustable-rate loans reset, and will require much more stringent criteria for interest-only borrowers.
During the housing boom, borrowers increasingly used adjustable-rate mortgages with low initial rates to buy bigger homes and banked on ever-rising values to refinance before payments rose higher. When prices stopped rising, more borrowers weren't able to sell or refinance to avoid higher payments. That sent defaults soaring. Fannie and its smaller rival, Freddie Mac, were taken over by the government through a legal process known as conservatorship in September 2008 as rising losses threatened to wipe out thin capital reserves. So far, Fannie and Freddie have required more than $126 billion in taxpayer infusions, a number that is likely to grow.
Interest-only mortgages, which allow borrowers to defer principal payments for the first five or 10 years, accounted for just 6.6% of Fannie's total loan book at the end of 2009 but were responsible for one third of all losses in the fourth quarter. Nearly one in five interest-only loans were 90 days or more past due at year end, and one-quarter of the loans had loan-to-value ratios that exceeded 125%. Freddie Mac said earlier this year that it would stop buying interest-only loans in September. Fannie said it will continue to offer such loans, but it will require borrowers to have credit scores of at least 720 and 30% equity. Borrowers must also have at least two years worth of cash reserves remaining after closing.
For adjustable-rate mortgages that reset within their first five years, lenders will have to qualify borrowers under higher payment levels, using the greater of either the current interest rate plus two percentage points, or the current interest rate plus the extra margin charged by the lender. "Our goal is to make sure consumers can sustain their mortgages and remain in their homes over the long term, while helping our lender partners offer a range of mortgage products for qualified borrowers," said Marianne Sullivan, a senior Fannie Mae risk-management official. Adjustable-rate mortgages accounted for one in six loans made by Fannie in 2006, but just 3% of such loans made last year. Interest-only loans, which accounted for 15% of all loans made by Fannie in 2007, represented just 1% of total lending volume in 2009.
Repaying Taxpayers With Their Own Cash
by Gretchen Morgenson
As we inch closer to a clearer understanding of the products and practices that unleashed the credit crisis of 2008, it’s becoming apparent that those seeking the whole truth are still outnumbered by those aiming to obscure it. This is the case not only on Wall Street but also in Washington. Truth seekers the nation over, therefore, are indebted to Senator Charles E. Grassley, Republican of Iowa, who in recent days uncovered what he called a government-enabled “TARP money shuffle.” It relates to General Motors, which on April 21 paid the balance of its $6.7 billion loan under the Troubled Asset Relief Program.
G.M. trumpeted its escape from the program as evidence that it had turned the corner in its operations. “G.M. is able to repay the taxpayers in full, with interest, ahead of schedule, because more customers are buying vehicles like the Chevrolet Malibu and Buick LaCrosse,” boasted Edward E. Whitacre Jr., its chief executive. G.M. also crowed about its loan repayment in a national television ad and the United States Treasury also marked the moment with a press release: “We are encouraged that G.M. has repaid its debt well ahead of schedule and confident that the company is on a strong path to viability,” said Timothy F. Geithner, the Treasury secretary.
Taxpayers are naturally eager for news about bailout repayments. But what neither G.M. nor the Treasury disclosed was that the company simply used other funds held by the Treasury to pay off its original loan. Neil M. Barofsky, the inspector general overseeing the troubled asset program, revealed this detail when he spoke before the Senate Finance Committee on April 20. “So it’s good news in that they’re reducing their debt,” Mr. Barofsky said of G.M. But he went on to note that G.M. was using other taxpayer money to make the loan repayment, according to the transcript of his testimony.
Armed with this information, Mr. Grassley fired off a letter to Mr. Geithner on April 22, asking for details of the transaction. “I am concerned ... that this announcement is not what it seems,” he wrote. “In fact, it appears to be nothing more than an elaborate TARP money shuffle.” Mr. Grassley heard back from the Treasury last Tuesday. Herbert M. Allison Jr., assistant secretary for financial stability, confirmed that the money G.M. used to repay its bailout loan had come from a taxpayer-financed escrow account held for the automaker at the Treasury.
Emphasizing that the cash in the account was “the property of G.M.,” Mr. Allison said that the department had approved the company’s use of the money to retire the original debt because it was “consistent with Treasury’s goal of recovering funds for the taxpayer and exiting TARP investments as soon as practicable.” It’s certainly understandable that G.M. would want to spin its repayment as proof of improving operations. But Mr. Grassley said he was troubled that the Treasury went along with the public relations campaign and didn’t spell out how the loan was retired.
“The public would know noth ing about the TARP escrow money being the source of the supposed repayment from simply watching G.M.’s TV commercials or reading Treasury’s press release,” Mr. Grassley said in a speech on the Senate floor last Wednesday, saying that “many billions” of federal dollars remained invested in G.M. “Much of it will never be repaid,” Mr. Grassley added. “The Congressional Budget Office estimates that taxpayers will lose around $30 billion on G.M.” (Taxpayers still own $2.1 billion in preferred stock of G.M. and almost 61 percent of its common equity.)
Greg Martin, a G.M. spokesman, said the company had made no misrepresentations about its repayment. “The bottom line is, our strong business performance has put us in the position that we don’t need these funds,” he said, referring to the cash in the escrow account. “G.M. is performing much better than anyone expected and that does represent a significant milestone for the company.” And Ron Bloom, senior adviser to Mr. Geithner, bristled at Mr. Grassley’s criticism. “The Treasury Department has tried to be as straight as humanly possible,” he said in an interview. “We have never not been clear about exactly what we paid, exactly the terms of the investment. I’m finding it hard to find anyone obfuscating about this.”
Of course, there is much joy in Mudville when a recipient of government aid repays its obligations. And it is also natural that the administration is keenly interested in reassuring taxpayers that losses on their bailout billions will be smaller than expected. Still, employing spin and selective disclosure is no way to raise taxpayers’ trust in our nation’s leadership. In an interview, Mr. Grassley said the Treasury had stopped “denying” that G.M. used federal funds to repay its TARP loan, but the fact that Treasury hadn’t been upfront about it still troubled him.
“It emphasizes how misleading Treasury was and how misleading G.M. is as well,” said Mr. Grassley. “I hope Treasury learns its lesson, and that is: Tell it like it is, and if you tell it like it is you don’t get egg on your face.”
Goldman Loses Room to Maneuver After Public Testimony
by Joshua Gallu
Goldman Sachs Group Inc. may have backed itself into a corner by speaking out quickly to counter fraud claims by the U.S. Securities and Exchange Commission. In the two weeks since the SEC filed its lawsuit, Goldman Sachs has released multiple written defenses, sent executives to Capitol Hill for sworn testimony and put Chief Executive Officer Lloyd Blankfein on television to explain the firm’s conduct as the housing market soured. While broadcasting its story, the New York investment bank also has given regulators, lawmakers and law enforcement agencies material to scour for contradictions that could weaken its defense.
SEC attorneys are already poring through the April 27 Senate testimony of Fabrice Tourre, the 31-year-old banker at the center of the lawsuit, looking for any deviation from sworn statements he made during the agency’s investigation, according to a person familiar with the probe who declined to be identified because the matter isn’t public. “Going under oath and committing yourself before you have any idea what kind of a case might be brought against you -- and more particularly what the evidence in that case might be -- is going to seriously curtail a defense lawyer’s ability to find running room to defend you,” said Samuel Buell, a former federal prosecutor who is now a law professor at Washington University in St. Louis.
Before the hearing, Tourre and Blankfein, 55, were interviewed under oath by the Senate Permanent Subcommittee on Investigations. Senator Carl Levin, the Michigan Democrat who heads the panel, said he’s looking into whether they “tried to fudge” their responses in the public hearing this week. Blankfein will appear next week at the annual shareholders meeting to answer questions related to the lawsuit.
Robert Khuzami, the SEC’s chief of enforcement, said in a closed meeting with Congressional staff on April 29 that it wouldn’t be appropriate to discuss whether there are settlement talks taking place, according to one person who attended and spoke on condition of anonymity because the briefing was private. Khuzami also declined to comment on why Tourre was the only individual named in the lawsuit, the person said. The SEC’s April 16 lawsuit revolves around whether the firm should have told investors in 2007 that hedge fund Paulson & Co., helped pick the underlying securities for a collateralized debt obligation -- and then bet against it. Paulson wasn’t accused of any wrongdoing.
Goldman Sachs’s Strategy
While locking in testimony this early in the litigation process posed risks, it was part of Goldman Sachs’s strategy, according to a person with direct knowledge of the firm’s defense. Tourre’s public statements make it less likely that he could change his story later and negotiate a lesser penalty with the SEC in return for information that could be damaging to the firm or other executives, the person said. Tourre, whose legal fees are paid by Goldman Sachs, said he “categorically” denies the SEC’s allegations. He may have testified to save his reputation and career, Buell said.
“These guys’ considerations aren’t just legal,” said Buell. “They have to do with public relations, with reputation, with their ability to continue to function the way they want to in the business world.” Goldman Sachs’s stock dropped 13 percent on the day the SEC announced its case and declined 9.4 percent yesterday after reports that federal prosecutors in New York are investigating the matter to determine whether to pursue a criminal fraud case.
Along with two analyst downgrades, the scrutiny “puts the pressure” on Goldman Sachs to try to settle sooner rather than later, Matt McCormick, an analyst at Bahl & Gaynor Inc. in Cincinnati, which manages about $2.8 billion, said yesterday in a Bloomberg Television interview. In terms of public opinion, McCormick said, Goldman Sachs has “already been condemned, the question is the price.”
Justice probe of Goldman goes beyond deals cited by SEC
by Zachary A. Goldfarb and Jerry Markon
The Justice Department's criminal investigation into Goldman Sachs goes beyond the financial transactions targeted by the Securities and Exchange Commission in the civil fraud suit brought against the firm last month, law enforcement sources said Friday. The Justice Department probe began weeks ago and is essentially on a parallel track with the SEC investigation, the sources said. While prosecutors and investigators are focusing on some of the same mortgage-related transactions as the SEC, the sources said, the Justice Department has cast a wider net.
Investors pounded Goldman Sachs shares on Friday as it became increasingly clear that the Wall Street bank's problems are growing. After initial news media reports about the criminal investigation, investors sent Goldman shares down 9.4 percent, or $15.04, to $145.20. It was another brutal day for a firm that survived the worst of the financial wreckage of the past two years. Since the SEC filed its suit April 16, Goldman's shares have lost 20 percent of their value, costing investors $20.6 billion in market value.
Goldman's stock price remains far higher than it was during the depths of the financial crisis in fall 2008. The firm's shares have essentially doubled in price since then as the company quickly returned to the black, seeing fewer losses on subprime mortgages than competitors and making significant trading profits with the help of government support.
Other actions pending
But analysts said the criminal probe and the civil case are just two of several developments that could threaten Goldman's reputation and bottom line in coming months. The firm also was the subject of a searing Senate investigative report this week examining Goldman's role in the financial crisis. Goldman's bottom line could also suffer if the Senate, now debating reforms to financial regulation, adopts proposed changes to limit trading in derivatives and certain investment activities at banks, for instance owning hedge funds.
Working alongside advocates for other big banks and industry trade groups that share similar concerns, Goldman's well-heeled roster of lobbyists have been meeting with the staff of key committee members, such as the financial services and agriculture committees in both the House and Senate. Banking analysts at Standard & Poor's and Bank of America-Merrill Lynch downgraded Goldman's stock on Friday. "Though traditionally difficult to prove, we think the risk of a formal securities fraud charge, on top of the SEC fraud charge and pending legislation to reshape the financial industry, further muddies Goldman's outlook," Matthew Albrecht, an analyst at Standard & Poor's, wrote Friday.
The U.S. attorney's office in Manhattan and the FBI are conducting the criminal probe, which sources said has been underway for weeks. Sources said a decision on whether to file any charges has not been made. The U.S. attorney's office in Manhattan declined to comment. Goldman said it would cooperate with requests for information. The SEC filed a civil securities fraud case against the firm two weeks ago, and a source familiar with the matter said the SEC had referred that investigation to the Justice Department for possible criminal prosecution.
But law enforcement sources said the probe by the Manhattan U.S. attorney's office -- which is known for aggressively investigating financial fraud cases -- was not based on an SEC referral and was underway before the SEC announced the civil case April 16.
High legal threshold
The Justice Department typically investigates high-profile cases of securities fraud, but the threshold for criminal prosecution is significantly higher than that of civil cases, and such investigations are highly complex. The threat of criminal prosecution can doom a business. A criminal case ruined the Wall Street firm Drexel Burnham Lambert in the 1980s even though it settled.
The SEC says Goldman and employee Fabrice Tourre broke the law and committed fraud when they sold clients a complex investment linked to the value of home loans that was secretly designed to fail. Another firm, Paulson & Co., a hedge fund, helped Goldman create the investment and planned to bet against it. The SEC says the relationship was not disclosed to Goldman's clients, ACA Financial Guaranty and the German bank IKB. Goldman and Tourre have denied any wrongdoing. Goldman says that ACA and IKB were sophisticated investors and that disclosure of Paulson's role was not required.
The Justice Department suffered a setback last year with the failure of the first major criminal case to arise from the financial crisis: the prosecution of two Bear Stearns hedge fund managers. A jury rejected securities fraud charges against the hedge fund managers, who ran funds linked to subprime mortgages, after presenting evidence that the men knew about risks but did not disclose these to investors.
The cases against Bear Stearns and Goldman Sachs have some overlap. One of the subprime-linked securities that contributed to the collapse of the Bear Stearns hedge funds was assembled by Goldman and sold under its Abacus program, which was the subject of the SEC suit and the Senate report this week. Securities lawyers have said that the Bear Stearns case sent a chilling message to the Justice Department after jurors said the prosecution's evidence, drawn in large part from internal company e-mails, was not persuasive. Lawyers said the Justice Department would need a very strong case to defeat Goldman.
They also said the criminal probe could complicate the SEC case as it moves to trial. Facing criminal prosecution, Goldman employees might decline to testify and then invoke the Fifth Amendment if the SEC seeks new depositions for the trial, as is common. However, in a civil case, unlike in a criminal case, invoking the Fifth Amendment can be held against you by a judge or jury.
U.S. Faces High Stakes In Its Probe of Goldman
by Evan Perez And Susanne Craig
The criminal investigation into whether Goldman Sachs Group Inc. or its employees committed securities fraud is a potent reminder of the pressure on the Justice Department to land a big fish on Wall Street. But the agency also is under pressure to show it can win big cases without cutting corners. "We're here not to win cases, but to do justice," Attorney General Eric Holder said in an interview before The Wall Street Journal reported that the U.S. attorney's office in Manhattan has launched a criminal probe of Goldman Sachs in connection with the securities firm's mortgage trading. "If we focus on that, we'll win the cases that we need to win."
As the Justice Department digs in for what is likely to be a long, complicated and contentious investigation, federal prosecutors are being pushed by their bosses to avoid the overzealousness that has led judges to reprimand some of them and even throw out criminal charges. Earlier this year, Mr. Holder appointed a senior prosecutor and a team of more than two dozen people to make sure prosecutors are sharing with defense lawyers any evidence that could be favorable to their clients.
The move followed a series of botched prosecutions that include the December dismissal of stock-backdating charges against Broadcom Corp. executives. A federal judge said prosecutors intimidated key witnesses and "compromised the integrity of the trial." Goldman Sachs denies any wrongdoing and has shown no signs of backing down to either a separate Securities and Exchange Commission fraud lawsuit filed April 16 or the preliminary criminal inquiry by federal prosecutors.
In a sign of how much is riding on the Goldman case, the company's shares fell $15.04, or 9.4%, to $145.20 in 4 p.m. New York Stock Exchange composite trading Friday. At least two securities analysts cut their ratings on the stock, citing Goldman's deepening legal morass. "Most such probes end inconclusively, with no charges filed," wrote Guy Moszkowski, an analyst at Bank of America Merrill Lynch, who cut his rating to "neutral" from "buy" and lowered his price target for the shares to $160 from $220. "However, it is very difficult to see the shares making further progress until the matter has been resolved."
Standard & Poor's Equity Research analyst Matthew Albrecht put a "sell" rating on Goldman and reduced his price target to $140 from $180. "Though traditionally difficult to prove, we think the risk of a formal securities fraud charge, on top of the SEC fraud charge and pending legislation to reshape the financial industry, further muddies Goldman's outlook," Mr. Albrecht wrote. So far, the Justice Department has little to show from its investigations of potentially illegal behavior on Wall Street related to the financial crisis. In November, for instance, jurors in Brooklyn, N.Y., acquitted two former Bear Stearns Cos. hedge-fund managers, expressing concern that the men were being made into scapegoats.
At an April hearing before the Senate Judiciary Committee, Sen. John Cornyn (R., Texas) pressed Mr. Holder to explain the shortage of trials. "We simply haven't had the people who were guilty of criminal conduct brought to justice and tried in public and punished for committing crimes that the American people are paying for," Mr. Cornyn said. In the Journal interview, Mr. Holder said it is his job to "insulate people from feeling that kind of pressure." "Even though we might want to focus on a particular priority, it doesn't mean we want people to do anything but the right thing."
About 5,300 prosecutors have undergone refresher courses on how to fight fairly. Justice Department officials are preparing new guidelines on what types of evidence need to be shared with defense lawyers. Mr. Holder wiped clean the 2008 bribery conviction of former Alaska Sen. Ted Stevens because evidence was mishandled by prosecutors. Two senior prosecutors were reassigned and an independent investigation into the misconduct is continuing. In April 2009, a Miami federal judge reprimanded two prosecutors for acting in a "win at all cost" manner in the case of a doctor facing drug charges, including taping conversations between an informant and defense lawyer.
"There's an enormous pressure on prosecutors to win," said David Markus, the lawyer whose conversations were taped in the Miami case. Judge Reggie Walton of the U.S. District Court for the District of Columbia said more attention to how cases are handled mightn't be enough, pointing to a recent case in which prosecutors were outgunned by defense lawyers who enjoyed better technology and seemed to know the government's evidence better than the government itself. The changes pushed by Mr. Holder also include improvements in evidence-handling, such as closing the technology gap with defense lawyers.
The Justice Department's evidence-related changes, led by Andrew Goldsmith, a senior prosecutor with two decades of experience, could be particularly important in complex financial cases such as the Goldman Sachs investigation, where volumes of evidence usually are stored electronically. Later this year, the Justice Department will select five to 15 cases to use a new case-management system. U.S. District Court Judge Emmet Sullivan, whose ruling in the Stevens case prompted Mr. Holder to act, has called for nationwide rules that could set punishments for prosecutors who don't share evidence properly. Judge Walton and other judges have expressed concern that the department could slip once Mr. Holder leaves or the spotlight fades. The Justice Department says such a rule is unnecessary.
Goldman’s Shares Plunge on Inquiries and Downgrades
by Louise Story and Michael J. De La Merced
Already facing investigations on two fronts into its practices in the mortgage market, Goldman Sachs came under pressure from investors as well on Friday. After reports on Thursday evening that federal prosecutors had opened an investigation into trading at Goldman, raising the possibility of criminal charges against the Wall Street giant, the firm’s stock was downgraded on Friday by two analysts. Standard & Poor’s lowered its rating from hold to sell, and Bank of America Merrill Lynch dropped its rating from buy to neutral, citing the mounting investigations.
Investors responded by sending the stock down 9 percent in midday trading, to $145.89, contributing to an overall decline in financial shares on Wall Street. The financial impact of Goldman’s troubles continues to mount. Since the Securities and Exchange Commission announced on April 16 that it had filed a civil fraud suit against the firm, its stock is down 20 percent, removing about $20 billion from its market capitalization. The drop is all the more striking given that Goldman delivered a blockbuster quarterly report last week, with first-quarter earnings doubling from last year.
Goldman has vigorously denied the accusations by the S.E.C., which accused the firm of defrauding investors involved a complex mortgage deal known as Abacus 2007-AC1. On Thursday evening, people familiar with the matter said the S.E.C. had referred its investigation to prosecutors for the Southern District of New York, which has now opened its own inquiry. While the investigation was said to be in a preliminary stage, the move could escalate the legal troubles swirling around Goldman.
Federal prosecutors would face a higher bar in bringing a criminal case against Goldman, whose role in the mortgage market came under sharp scrutiny this week during a marathon hearing in the Senate. In contrast to civil cases, the burden of proof is higher in criminal ones, where prosecutors must prove their case beyond a reasonable doubt. The stakes are high for Goldman, but they are also high for the United States attorney’s office. Prosecutors from the Eastern District of New York lost a case last year filed against two hedge fund managers at Bear Stearns, whose collapse presaged the turmoil on Wall Street.
Prosecutors built much of that case around internal e-mail messages at Bear Stearns, much the way the S.E.C. and senators have pointed to e-mail messages at Goldman in which employees had disparaged investments that they were selling to their customers. In the end, however, prosecutors were unable to prove to a jury any criminal wrongdoing by the Bear Stearns employees.
A spokesman for Goldman declined to say whether the bank knows about a criminal case, but he said “given the recent focus on the firm, we’re not surprised” to learn about a criminal inquiry. The spokesman said Goldman would cooperate with any investigators’ requests for information. A spokeswoman for the Southern District also declined to comment.
The opening of the Justice Department investigation was first reported Thursday evening by The Wall Street Journal’s Web site. Goldman has said it will defend itself against the S.E.C.’s accusations. The firm’s executives discussed the case last week during their quarterly earnings call, and this week, they testified about their mortgage operations in a nearly 11-hour hearing in Washington before a Senate subcommittee. That hearing focused broadly on Goldman’s mortgage operations, and the Senate subcommittee released reams of new internal documents from Goldman. The Senate Permanent Subcommittee on Investigations is looking into many other mortgage deals beyond the one cited by the S.E.C.
The deal at the heart of the S.E.C. case was one of 25 mortgage securities that Goldman created in a program it called Abacus. The agency has hinted that it may expand its inquiry to other Wall Street firms. Those securities were synthetic collateralized debt obligations, which are bundles of derivatives that mimic the performance of mortgage bonds. The securities allowed people who believed that the housing market would collapse to buy insurance against certain mortgage bonds they thought might fail. When those mortgage bonds did fail, the investors in the Abacus deals suffered major losses.
The Abacus deals were, however, very profitable for the parties that were negative on the housing market. In the Abacus 2007-AC1 deal, the hedge fund manager, John A. Paulson, raked in about $1 billion when the bonds he helped select hit trouble. Mr. Paulson has not been named in the S.E.C.’s case because he was not involved in marketing and selling the deal. Many in Congress have been pressing for a criminal inquiry. This week, 62 House members sent a letter to the Justice Department asking it to conduct an investigation into Goldman’s actions.
Goldman didn't tell SEC about mortgage moves for months
by Greg Gordon and Chris Adams
In December 2006, Goldman Sachs embarked on a frantic effort to shed billions of dollars in risky mortgage securities and purchase exotic insurance to protect itself against what it had concluded could be the collapse of America's housing market. Yet for nine months, until Sept. 20, 2007, the Wall Street giant didn't disclose its actions in key filings with the Securities and Exchange Commission, in telephone conferences with analysts or in its press releases. A McClatchy review of hundreds of pages of subpoenaed company records released by a Senate panel Tuesday, as well as Goldman's SEC filings, has revealed how closely the company guarded its secret exit plan.
Goldman's failure to tell the investors who bought its risky mortgage securities that it had made an array of wagers against housing is at the heart of the furor now enveloping the nation's premier investment house, the only major Wall Street firm to exit the subprime mortgage market with minimal damage. By the time Goldman finally began to divulge its strategies to the SEC, credit markets were freezing up and the investment bank was well on its way to making billions of dollars in revenue from its negative bets, known in the industry as "shorts."
Consider this contrast between the firm's public face and its private maneuvering: On March 7, 2007, Goldman's chief financial officer, David Viniar, chaired an internal meeting of the company's risk committee. Notes of the meeting report that the committee discussed the "accelerating meltdown" among subprime mortgage lenders, the progress of the company's mortgage division in "closing down every subprime exposure possible" and signs that subprime woes were beginning to affect commercial real estate.
Sheara Fredman, a vice president in the company's finance division, also sent Viniar "talking points" in advance of the firm's quarterly earnings announcement stressing that that its short bets had enabled Goldman's mortgage division to earn $266 million during the quarter despite the deteriorating subprime market. During the March 13 conference call with analysts, however, Viniar made no mention of Goldman's short bets or the $266 million gain. Instead, he said the market had seen "a little bit of nervousness" but the housing weakness had been "so far largely contained."
It's still unclear whether the federal laws designed to protect consumers from deceptive marketing required Goldman to reveal more information earlier than it did. Goldman spokesman Samuel Robinson said: "We are not required to disclose individual trading positions. Rather, we disclose the financial performance of the firm. In this regard, net revenues from the residential mortgages business represented around 1 percent of the firm's total net revenues in 2007." The wagers, however, saved Goldman from billions in losses.
SEC disclosure rules revolve around the idea that information that's "material" to a company's or an investment's fortunes should be disclosed, but it's not clear whether Goldman will face legal liability for choosing not to reveal its exit plan to its shareholders, who benefited from the strategy. However, Goldman's limited disclosures in the offering circulars it gave the investors that bought its mortgage securities could cause legal problems.
At issue is whether Goldman's bets against the housing market were so "material," or relevant to investors, that their disclosures could have convinced them not to buy its products. Without purchasers for its risky securities, Goldman's exit strategy would have flopped. Materiality in such cases "is a complicated, mixed question of law and fact, decided on a case-by-case" basis, said Frank Partnoy, a University of San Diego law professor, "and we won't know the answer until a judge rules."
Asked why Goldman disclosed in late 2007 but not earlier, that it had been "net short" for most of the year, company spokesman Robinson said: "Companies don't report on every single area of activity in every quarter." He said that the September 2007 disclosure was in response to "intense investor and analyst interest." Goldman has stressed that it limited its mortgage dealings to Qualified Institutional Investors such as pension funds and insurance companies that have fewer legal rights to disclosure about securities' risks.
Goldman's decision to retreat from the cresting housing market came at a senior-level meeting Viniar organized on Dec. 14, 2006, after its mortgage traders reported losses for 10 straight days. The day after the meeting, Goldman mortgage chief Dan Sparks instructed his team in an e-mail to reduce the company's inventory of billions of dollars in risky mortgage loans, to cash out losing bets that home prices would keep rising, to monitor the current value of its offshore mortgage securities more closely and to "be ready for the good opportunities that are coming." Three days later, Fabrice Tourre, the mortgage trader who's now a defendant in the SEC suit, wrote that his unit had "a big short on."
As the traders escalated their bets against the housing market in the ensuing weeks, Goldman President Gary Cohn and other top executives paid close attention. As subprime mortgage lenders began to collapse under the weight of rising loan defaults, Goldman was cashing in. In a Feb. 22, 2007 e-mail, Sparks told traders Josh Birnbaum, Michael Swenson and David Lehman to cash in $3 billion in bets.
"You called the trade right, now monetize a lot of it," he wrote. "You guys are doing very well." During the same period, Goldman marketed more than $11 billion in securities backed by risky mortgages — $4.8 billion in ubprime loans to questionable borrowers, and $6.2 billion in so-called Alt A loans, a slightly less risky category whose borrowers had low credit scores, according to company prospectuses filed with the SEC.
Goldman's "short" bets, which it began to place as early as 2005, were carried out using insurance-like contracts known as credit-default swaps. Goldman would pay an annual premium that usually amounted to 1 to 2 percent of the face value of the contract but collect big if the securities collapsed. The newly released Goldman records show that it executed the strategy by:
- Selling bundles of securities in the Cayman Islands. At least 16 of these deals included exotic bets on subprime securities in which Goldman would profit if the underlying loans defaulted. Goldman stood to make $2 billion if one deal, known as Hudson Mezzanine SP, cratered. The securities initially received the top investment-grade rating of Triple A on Dec. 27, 2006, but had been reduced to junk status on July 31, 2008.
- Using swaps to make short bets on companies tied to the housing market. According to a person familiar with these bets, Goldman wagered against: Washington Mutual, Inc., which later collapsed in the biggest bank failure in U.S. history; Countrywide Mortgage, Fremont General Corp. and National City Corp., subprime lenders that failed, and Wall Street investment banks Bear Stearns and Merrill Lynch, both of which were rescued by taxpayers after running up huge mortgage debt.
- Making huge short bets by buying swaps on a subprime index on the private London exchange that it helped create and profiting when defaults rose in a basket of 20 subprime mortgages.
Despite the drama inside 85 Broad Street, Goldman's former headquarters, what the company released to the public in its quarterly disclosure statements was less than dramatic.
In its first quarter 2007 public earnings release, Goldman observed "significant weakness" in the subprime sector, but Viniar said those problems thus far had been "largely contained." During the first half of 2007, Goldman continued to peddle exotic deals pegged to the performance of mortgage-backed securities while it shorted other aspects of the mortgage market. Several offshore deals were given priority over those requested by clients, the Senate investigators found.
In an e-mail pressing the sales staff to unload a deal called Timberwolf, a top Goldman mortgage executive urged the marketing team to "get 'er done," promising "ginormous credits" as a reward. The value of the product later plummeted. In June 2007, Goldman soft-peddled its increasingly dark view of the mortgage market. In a quarterly filing to the SEC, the company glossed over the calamity its traders were seeing on a daily basis, reiterating that, "The broader credit environment remained strong, although the subprime sector within the mortgage market continued to be weak."
When Viniar spoke with analysts, he added that the mortgage business _ in the context of all of Goldman's business _ "is just not that big." Yet in an internal e-mail on July 25, when Cohn wrote him to point out big write-offs in subprime mortgages, Viniar responded: "Tells you what might be happening to people who don't have the big short." In September, Goldman finally acknowledged its short position _ although other documents and its internal e-mails indicate that the company had been net short for most of the year.
"Significant losses on non-prime loans and securities were more than offset by gains on short mortgage positions," the company reported on Sept. 20. When he spoke to analysts about those results, Viniar said that the company's overall "short position was profitable." But, he added that under the company's policy not to reveal any unit's results: "I can't tell you the actual profits of the shorts." Not until October, after the SEC's accounting branch pressed Goldman for more details of its subprime exposure, did Goldman reveal in a letter that it held a net short subprime position "during most of 2007 . . . and therefore stood to benefit from declining prices in the mortgage market."
A week later, Goldman's controller, Sarah Smith, informed the SEC that between Nov. 24, 2006, and Aug. 31, 2007, Goldman had reduced its investment in subprime mortgages from $7.8 billion to $462 million. In short, Goldman turned a potential financial catastrophe into a profit. On Tuesday, Blankfein said the firm's net profit from its mortgage business was less than $500 million. The uproar over Goldman's behavior reached a crescendo this week, when the Senate Permanent Subcommittee on Investigations took sworn testimony from Goldman chief executive Lloyd Blankfein and six other current and former company executives.
It also was disclosed that the Justice Department is considering a criminal inquiry of whether Goldman fraudulently misled investors in its subprime mortgage deals. These developments came after the SEC filed a civil fraud suit April 16 against the company and one of its vice presidents, Fabrice Tourre. Both have denied wrongdoing. During the 10-hour Senate hearing, Blankfein and the other company executives denied that Goldman had bet massively "short" on the housing market. Blankfein also said that Goldman had merely acted as a market maker carrying out its clients' wishes.
Michigan Democratic Sen. Carl Levin, the panel chairman, pilloried Blankfein for failing to own up to his firm's harm to clients that absorbed huge losses on subprime securities peddled by Goldman's sales crew, some of whom privately derided several of its deals as "junk," "shitty" and "crap" in internal e-mails. Subcommittee members from both political parties were infuriated that Blankfein and Viniar refused to acknowledge that Goldman's net short bets against the housing market, peaking at $13.9 billion on June 25, 2007, amounted to a huge negative wager. "The question is did you bet big-time in 2007 against the housing mortgage business? And you did," Levin told Blankfein. "No, we did not," Blankfein shot back.
Derivatives Rules Would Cost Banks Billions, 41% of Goldman Earnings
by Cyrus Sanati
Goldman Sachs could lose up to 41 percent of its earnings if Congress approves tighter regulation of the derivatives market, according to an analysis by Bernstein Research. That’s equivalent to wiping away $3.9 billion in Goldman’s earnings this year if the stricter regulations were in effect for the entire 12 months, according to a subsequent analysis of the numbers by DealBook using Bernstein’s 2010 earnings-per-share estimates.
Other major banks, including Citigroup, Morgan Stanley, JPMorgan Chase and Bank of America, would also withstand cuts of billions of dollars in their earnings if the derivatives rules currently being considered by the Senate are put in place. Estimating how stricter rules on derivatives would affect the bottom line of banks relies on some big assumptions, so Bernstein’s estimates should be taken with some caveats. Nevertheless, the assumptions Bernstein makes in its analysis are probably as close to the mark as any, given the lack of disclosure by the banks on their trading activities.
For example, banks do not break down their trading revenue by function – so it is hard to find out what percentage of a bank’s trading revenue comes from derivatives trading. Bernstein therefore has to estimate that number, fully knowing that it could fluctuate for each bank. It then estimated the percentage of profit that would be lost under the proposed derivatives regulations.
That required further assumptions, given that the legislation is pending and could be changed at any time. The big wild card is how much of the business would be taken public. If the bids and asks for over-the-counter derivatives transactions are forced into the open, the spreads that the banks make brokering the deals will fall. Estimating how much they will fall is difficult.
In performing their sensitivity analysis, Bernstein therefore had two major sliding assumptions: the percentage of trading revenue that each bank derives from derivatives trading and the percentage of that revenue that could be at risk of going away if strict derivatives legislation passes. The impact on the bottom line varies greatly, as some banks are more dependent on trading revenue than others.
Take Goldman Sachs. If the bank derives 30 percent of its trading revenue from derivatives and 50 percent of that amount is at risk of going away, the firm’s total earnings would fall by 15 percent. That would be a $1.43 billion hit to the $9.53 billion that Bernstein estimates the bank will earn in 2010. Bernstein’s worst-case scenario was if Goldman derived 60 percent of its revenue from derivatives trading, with 70 percent of that revenue at risk. Goldman would then be facing a 41 percent decline in its earnings, equivalent to a $3.9 billion hit to its earnings if calculated using 2010 estimates.
JPMorgan is a distant second. If it derives 30 percent of its trading revenue from derivatives and 50 percent of that revenue is at risk of going away, the firm’s earnings would fall by 7 percent. That is equal to an $890 million hit to its 2010 estimated earnings of $12.74 billion. The worst-case scenario, using the same assumptions for Goldman, would cause a 14 percent hit to earnings, equivalent to a $1.78 billion reduction of its 2010 estimated earnings. In a conference call with investors this month, Jamie Dimon, JPMorgan’s chief executive, estimated that the proposed derivatives regulations could cost the bank several hundred million dollars to $2 billion in lost revenue. Given that the profit margin is high on derivatives trading, Bernstein’s estimates seem to be somewhat on the mark.
Meanwhile, Morgan Stanley could have a 9 percent hit to its earnings if 30 percent of its trading revenue comes from derivatives and 50 percent of that revenue was at risk. Bernstein’s worst case shows the bank losing 25 percent of its earnings, or $1.1 billion, based on 2010 estimates.
Citigroup and Bank of America would not be affected as significantly the other banks, because they derive a smaller proportion of their revenue from trading. Citi would see a 5 percent drop in the baseline scenario and a 15 percent drop in the worst-case scenario, equivalent to a $1.7 billion reduction in earnings, according to 2010 estimates. Bank of America would take a 4 percent hit in the baseline scenario and an 11 percent hit in the worst-case scenario, equivalent to a $1 billion earnings reduction, according to 2010 estimates.
Derivatives Measure Worries Banks
by Scott Patterson and Robin Sidel
A proposal gaining ground on Capitol Hill to force banks to spin off their derivatives-trading operations would represent a severe blow to one of Wall Street's most profitable businesses. Banks took in about $20 billion in revenues in 2009 on trading of derivatives, according to industry estimates of the size of the market for financial contracts tied to other assets, such as oil or mortgages. Bankers scrambled Monday to learn more about the spinoff proposal, which gained momentum this weekend when Senate Democrats folded the derivatives plan into their broader financial-overhaul package.
Critics have blamed derivatives as a culprit in the credit crisis, saying the lightly regulated and opaque markets froze up when traders feared some firms wouldn't be able to make good on their promises. The derivatives legislation would boost federal oversight and transparency of the market. The most controversial proposal is the provision to force banks that are eligible for financial assistance from the Federal Reserve and the Federal Deposit Insurance Corp. to spin off their derivatives-trading desks. If passed, that provision would represent one of the most dramatic shifts in how Wall Street works since the credit crisis struck.
While certain details of the proposal remained unclear, banks would likely be required to spin off their derivatives operations into separate companies, a move reminiscent of the Glass-Steagall Act of the 1930s that required commercial banks to spin off their investment-banking arms. Under another possible scenario, a bank could restructure the operations into a separate arm of the bank that didn't have federal backing. By breaking off derivatives operations from the banks, legislators hope to reduce the risk a meltdown in that market would threaten depositors and require a federal bailout.
Without their derivatives business, "the big banks will contribute less systemic risk, so it may be better for the taxpayer," said Morningstar analyst Matthew Warren Several Wall Street firms and industry experts maintain the proposal would do little to reduce risky behavior, while making the U.S. banking industry less efficient. Requiring spinoffs, they say, would throw derivatives trading into the hands of foreign institutions and lightly regulated hedge funds. They also said the new rules could force dealers to put up more capital, which could take capital away from lending to consumers and businesses.
Derivatives dealers need to hold a large chunk of capital, because clients want to be sure that dealers will be able to fulfill their obligations. Companies that purchase derivatives, ranging from airlines to farmers to oil producers, often strike multibillion-dollar contracts with dealer banks. Besides big banks, "who's going to have the balance sheet to support these positions?" said Howard Simons, a strategist at Bianco Research. "You need someone who has the balance sheet."
The Federal Reserve over the weekend tried to kill the provision, telling lawmakers in a letter that section of the overhaul bill "should be deleted." Passage would represent a particular setback for J.P. Morgan Chase & Co., which ranks as the nation's largest derivatives player, according to data from the Office of the Comptroller of the Currency. J.P. Morgan Chief Executive James Dimon said he supports a proposal to send standard derivatives contracts through an industrywide clearinghouse that can be monitored by regulators. He has opposed a requirement that all trades be moved onto an exchange, in part because it would inhibit the use of customized instruments.
Even those less-stringent proposals were expected to drain "several hundred million to a couple billion dollars" from the bank's annual revenue (which totaled $109 billion last year), Mr. Dimon said in a conference call with analysts earlier this month. Paul Miller, an analyst at FBR Capital Markets, said he was swamped Monday with questions from clients who wanted to know more about the proposal. Mr. Miller estimates that banks could lose anywhere between 2% to 5% of their return on equity from the proposal, though he also acknowledges that "if Washington takes this away from the banks, [the bankers] are sure going to work very hard to find something else" to make up the lost revenue.
Buffett Defends Goldman; Berkshire Posts Profit
by Scott Patterson and Erik Holm
Warren Buffett offered a vigorous defense of Goldman Sachs Group Inc. Saturday, saying the embattled firm hadn't engaged in improper activity and shouldn't be blamed for the losses of its clients. Goldman has been reeling from Securities and Exchange Commission allegations that the bank had engaged in fraudulent activities in relation to a mortgage deal called Abacus 2007-AC1. Goldman says it did nothing wrong.
Mr. Buffett's comments—which came early in the day at Berkshire Hathaway Inc.'s annual shareholders meeting—offer a powerful vote of confidence in Goldman, which has seen its shares slide since the SEC announced the investigation on April 16. Goldman's stock fell 9.4% on Friday alone after it emerged that the Manhattan district attorney's office was conducting a preliminary criminal probe into its mortgage-trading activities. "We have had a lot of very satisfactory transactions with Goldman Sachs," Mr. Buffett said.
The billionaire investor said he fully supported Goldman CEO Lloyd Blankfein. Asked if he could choose a successor for Mr. Blankfein, Mr. Buffett said: "If Lloyd had a twin brother I'd go for him." Speaking to a packed auditorium of some 40,000 investors hanging on his every word, Mr. Buffett said Berkshire Hathaway recorded a first-quarter profit of $3.6 billion, compared with a net loss of $1.5 billion a year earlier. Mr. Buffett said the company's results show that the global economy is showing significant signs of recovery for the first time. Operating profit was $2.2 billion, reversing a year-ago loss of $3.2 billion, he said, adding that individual units showed significant signs of improvement in March, after slight gains in prior months.
"What was sort of a sputtering recovery months ago seemed to pick up steam in March and April," Mr. Buffett said. "We're seeing a pretty good uptick." The audience's reaction to Mr. Buffett's comments on Goldman was tepid. While a number of comments by the Berkshire chairman in the morning were greeted with strong applause by the crowd—almost entirely made up of Berkshire investors—his comments on Goldman were largely met with silence. "I was surprised by how strong he stood by [Goldman] out of the gate and that he wasn't more critical of the Wall Street culture," said Justin Fuller, partner at Midway Capital Research & Management, which closely tracks Berkshire.
The SEC suit alleges that Goldman defrauded investors when it created a mortgage investment with the help of a bearish hedge fund and failed to disclose the fund's role and position. The suit is potentially of special concern to Mr. Buffett, known for his ethical standards. Ever since he was a small-town money manager in Omaha, where he has lived most of his life, he has lambasted the aggressive, self-serving tactics of Wall Street's banking elite.
Mr. Buffett, who invested $5 billion in Goldman at the height of the financial crisis, said he didn't believe that Goldman had acted improperly. Rather, counterparties to the deals, which plunged in value when the housing market fell apart in 2007, should be responsible for their own actions. Mr. Buffett said he believed that one of the banks that had purchased Abacus deals in the transaction, the Dutch bank ABN Amro Group, was a sophisticated investor. "It's a little hard for me to get terribly sympathetic for a bank that made a bad credit deal," said Mr. Buffett.
He said a firm that had acted as an intermediary in the deal, ACA Management, had drifted from its original business of insuring municipal bonds into structured finance, a more complicated and risky business. He said he believes most press accounts haven't properly explained ACA's business model. Mr. Buffett also said the fact that Paulson & Co., the New York hedge fund that worked with Goldman and ACA to structure the Abacus deal, was on the other side of the Abacus deal was irrelevant. "It doesn't make any difference whether it was Paulson on the other side of the deal or whether Goldman was on the other side of the deal or whether Berkshire was on the other side of the deal," he said.
Berkshire Vice Chairman Charlie Munger, who told The Wall Street Journal this week that Goldman was engaged in "socially undesirable" activities, told shareholders that he would have voted against SEC prosecution. But Mr. Munger indicated he believes Goldman may have come closer to the edge of suspect behavior than Mr. Buffett does. "I think it was a closer case than you do," he told Mr. Buffett during an exchange. Mr. Buffett said the charges against Goldman have hurt the bank's reputation. "There's no question that the allegation alone causes the company to lose reputation," he said. "The press of the past few weeks hurt the company and hurt morale."
But he said that the charges need to be proven if they are to have a lasting impact on Goldman. "I don't believe that the allegation of something falls within the category of losing reputation," he said. "If something is proven then you have to look at it." Paul Howard, an independent insurance analyst who tracks Berkshire, said the defense of Goldman wasn't surprising. "Buffett shows his loyalty to those who have helped him over the years," said Mr. Howard.
In a twist, Mr. Buffett said the SEC charges against Goldman have helped Berkshire Hathaway. He noted that Goldman could redeem Berkshire's $5 billion investment at any time, and that Goldman has an economic incentive to do so. The reason: Goldman is paying a 10% rate on the investment, coming to $500 million a year, or, as Mr. Buffett said at the meeting, $15 a second. He held up a hand and counted up the profit to illustrate the point. "Tick, tick, tick," said Mr. Buffett. "Goldman would love to get rid of that."
But Goldman likely believes that having Mr. Buffett as an investor can help its reputation. "Recent developments have probably delayed the calling of our preferred," said Mr. Buffett, who guzzled Coke and munched on See's Candies throughout the meeting. Mr. Buffett has also been taking some heat for a push he has made on Capitol Hill for exemptions for several large derivatives deals his firm has made in recent year. A bill before Congress could force Berkshire to post billions in collateral for the deals. In the past, Berkshire hasn't been required to put up much cash—if any—to back its derivatives transactions. Mr. Buffett said he's confident that his firm would likely not be required to post collateral on existing derivative contracts under the financial-overhaul bill currently before the Congress.
Mr. Buffett said he doesn't see any consequences "unless there's some sweeping requirement that all companies have to post collateral" on old contracts. Berkshire had lobbied to have such a provision added to the overhaul bill to clarify the requirements under the proposed law. Still, if required to put up such collateral, Berkshire would do so, he said. Berkshire has never paid dividends and Mr. Buffett is famous for shunning them. At the shareholder's meeting, he didn't explicitly say anything about a dividend nor did he utter the actual word. However, he said the company is now so large and generates so much cash that it might struggle to find investments that are both big enough and offer enough return.
"I think we can go out further than I thought 30 years ago," Mr. Buffett said. "But there is a limit. There will come a time when we cannot intelligently use 100% of the capital we've developed internally. Whatever is in the best interests of the shareholders will be done at this point." "I don't think he said anything that people weren't already thinking," said Jeff Matthews, the founder of hedge fund Ram Partners and author of "Pilgramage to Warren Buffett's Omaha." "Still, it was a little more specific and a little more emphasis than people are used to hearing." Mr. Howard, the insurance analyst, said Mr. Buffett was "leaving the option open for the future, probably after his death."
Banking regulation bill is too big to succeed
by Gillian Tett
When was the last time that you sat down and read a 1,300 page novel? In the sense of really reading it, understanding every page, and conducting an intelligent debate on the contents later? It is a question that investors, bankers, and politicians in America should ponder, not to mention those angry citizens who were protesting in New York on Thursday. After all, the debate about financial reform is reaching fever pitch in Washington and on Wall Street, as Republicans and Democrats bicker over reform bills – and bankers reel from the inquisition of Goldman Sachs on Tuesday. One curious facet to this debate is that almost nobody I have met in the banking or political world appears to have actually read much (let alone all) of those financial reform bills. Little wonder. Senator Chris Dodd’s basic bill currently runs to more than 1,300 pages, with more than 300 on derivatives alone. Numerous counter proposals are floating around too. It is a truly intimidating volume of paper, even before you start trying to talk about how centralised clearing houses, say, might actually work.
Such complexity has two important implications. First, it makes the future outlook for regulation in America extraordinarily uncertain. For quite apart from the unpredictable nature of the current strand of political populism, even if a bill is finally passed, it is going to take most investors and bankers a very long time to work out what exactly has been turned into law. Buried in those 1,300 pages are numerous clauses and sub-clauses, many of which have been largely ignored until now (partly because they strike most non-financiers as pretty dull). Yet, the fine print could turn out to be crucial in the coming years, in terms of shaping how banking is done. Or as one senior central banker recently confessed: “We keep tripping over things that even we barely knew were there.” This is not comforting.
The second point is that there is a good chance that the complexity will end up playing into the hands of the banks. After all, if anybody has enough resources to hire enough lawyers to analyse 1,300 pages of dense text, it will be them. And banks are supremely skilled at exploiting any loopholes in the law. After all, that is what they have done during much of the past decade, amid the financial innovation boom. There is little reason to think that will change now, courtesy of a 1,300 page bill. On the contrary, the more complex the bill, the more potential there will be for future legal arbitrage – not least because so few people understand it.
Is there any way to prevent this? Not easily. America prides itself in having a rules-based regulatory system, as opposed to the principles-based approach that has been used, say, in the UK. And to most American politicians and lawyers, the idea of ever moving towards a more principles-based approach seems deeply “un-American”, since it could hand more power to a whimsical government at the expense of the individual. And while London used to tout the benefits of its principles-based regulatory approach, Britain’s financial world has hardly covered itself in glory in recent years. Nevertheless, even if America is not about to toss away its rules-based system – which seems extremely unlikely – creating a 1,300 page bill which almost nobody understands hardly seems like progress. And the fact is that even in America, there are times when principles do matter. Just look, for example, at what has happened to Goldman Sachs.
Thus far, it is unclear whether the bank actually broke any legal rules in its Abacus deal; however, in the court of public and political opinion it has already been condemned as “guilty” for breaching moral principles (such as duty to protect the interests of clients) – even though such principles have never actually been set down. So it would be well worth adding another couple of pages to the reform bills. These would ideally set out, in clear and concise English, a dozen, or so, core principles to underpin all those rules.
Some might argue that the sub-title of the bill does that (namely to “promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘‘too big to fail’’, to protect the American taxpayer by ending bail-outs, to protect consumers from abusive financial services practices.”) But a bit more flesh on the bones, in easily understandable language, would help to concentrate minds. And even if principles per se never have any legal force, writing them down would at least define what the ultimate point of financial reform is supposed to be. Better still, it would provide a future benchmark to judge whether this bill is working or not. That can only be a good thing, not just for politicians, but for investors and all those angry voters, who currently stand to be the biggest victims of a world where complexity and the law has gone mad.
New Life for 'the Volcker Rule'
by Bob Davis
Former Federal Reserve Chairman Paul Volcker is 82 years old. He can't hear so well. And for a time he was outmaneuvered by President Barack Obama's economics team. But as the Senate moves toward the biggest rewrite of financial rules since the 1930s, Mr. Volcker's ideas are having a profound impact on the debate.
The Senate is considering writing into law what Mr. Obama calls "the Volcker rule," which would effectively bar banks from the risky and often lucrative practice of trading for their own accounts. The Volcker rule is aimed at undoing a side-effect of the bailouts of 2008 and 2009: An assumption that government will always rescue big financial institutions, and thus make it easier for them to borrow heavily to make risky bets. Mr. Volcker, now head of the president's economic recovery advisory board, proposes that the government's safety net be extended only to banks that stick to taking deposits and making loans, not to those that engage in proprietary trading for their own profit. Banks would be forced to give up such trading or surrender banking licenses. If they choose to retain proprietary trading, they would be allowed to fail.
"We'll give you a nice coffin and an easy cushion...but you're not going to be saved," Mr. Volcker said. "We're talking about changing the rules governing global finance for the next 25 or 50 years," said Harvard University economist Kenneth Rogoff. "Thought leaders like Paul Volcker help shape the accepted wisdom." On Jan. 21, Mr. Obama stood beside Mr. Volcker at a White House press conference and embraced the Volcker rule. The spirit, if not the letter, of Mr. Volcker's proposal is embodied in legislation pending in the Senate—and some senators are vowing to toughen the language before the bill is final, especially in the wake of civil securities-fraud charges against Goldman Sachs.
Details are still in flux, but bankers are alarmed. J.P. Morgan Chase & Co. and Barclays PLC oppose the proposal. Industry lobbyists argue that it isn't essential and are seeking to consign it to legislative purgatory. "Trading—proprietary or otherwise—didn't lead to the recent crisis," said Rob Nichols, president of the Financial Services Forum, an industry trade group. "Let's focus on correcting the major deficiencies in our current supervisory framework first."
At the outset, Treasury Secretary Timothy Geithner and White House economic adviser Lawrence Summers weren't convinced the Volcker rule would prevent future economic crises. Proprietary trading didn't ignite or deepen the current crisis, they argued, and the Volcker rule wouldn't have prevented it. Instead, the initial Obama regulatory blueprint they backed emphasized stiffened oversight of financial institutions and new government authority to take over failing financial firms. But while Mr. Volcker was relegated to overseeing a powerless advisory board, he has prominent allies, including Bank of England Governor Mervyn King and current and former Citigroup executives, some of whom have been pushing for his proposal.
Former Citigroup Chief Executive John Reed has said that combining investment and commercial banking was disastrous because investment bankers "overwhelmed the traditional culture" at the bank "and now Citi is in trouble." Current CEO Vikram Pandit recently wrote Mr. Obama: "I believe banks should be banks serving clients. I believe banks should not speculate with their capital." The 6-foot-8 Mr. Volcker is stooped nowadays. He walks slowly. But that didn't stop him from staging an energetic lobbying campaign for his proposal beginning last spring. His influence is evident. Rep. Paul Kanjorski (D., Pa.) said a March 2009 dinner with Mr. Volcker shaped a proposal, for which Mr. Kanjorski won House backing, that would enable regulators to dissolve major financial institutions even if they aren't bankrupt.
Meanwhile, as polls showed that the public viewed Mr. Obama as too friendly to Wall Street, he invited Mr. Volcker to the Oval Office on Oct. 28 along with Vice President Joe Biden and Messrs. Geithner and Summers to discuss regulatory approaches. Mr. Biden urged the president to back Mr. Volcker's provision, according to White House advisers, and objections from Messrs. Geithner and Summers faded. The president assigned Mr. Geithner to craft a proposal based on Mr. Volcker's ideas. The two men met with Mr. Summers at the White House on Dec 23. Mr. Geithner continued the talks with Mr. Volcker at the Treasury the next day, and said he told Mr. Volcker he would recommend that the president endorse a ban on bank proprietary trading, which Mr. Obama did at the Jan. 21 press conference.
Although Treasury officials and Mr. Volcker emailed back and forth about a "fact sheet" to explain how a Volcker rule would work, the White House didn't distribute it. That handicapped Mr. Volcker's advocacy on the Hill and he couldn't clearly define the trading practices he wanted banned. "It's like pornography. You know it when you see it," Mr. Volcker cracked at a February Senate hearing. "Well you might see it. But would the regulator see it?" responded Sen. Richard Shelby (R., Ala.). Wall Street watched apprehensively. Some sought to keep the provision from moving forward. Bankers and some economists warned that drawing a line between trading on behalf of customers and trading for profit would prove difficult.
Then came the charges against Goldman Sachs, reigniting controversy over the social utility—and potential conflicts of interest—of banks trading for their own profit. At a hearing, Goldman's finance chief said implementing the Volcker rule would hurt U.S. competitiveness. Senate Banking Committee Chairman Christopher Dodd, as part of a broader finance bill, is proposing to require a new council of regulators to study the issue for 60 days and then decide how to implement it. But two Democrats, Sens. Jeff Merkley (D., Ore.) and Carl Levin (D., Mich.), are seeking to amend the bill to toughen the language and force regulators' hand.
Another provision of the bill would go beyond what Mr. Volcker suggested and push banks out of the business of trading derivatives altogether. The issues are likely to be resolved on the Senate floor in May, and the outcome is unpredictable. Meanwhile, Mr. Volcker promises that he'll continue battling. "I am old. I might be old-fashioned, but I stick with it," he said.
SEC Cops Don't Need Guns and Badges on Their Beat
by Russell G. Ryan
When I worked at the Securities and Exchange Commission, I thought the only way my job could get better was if they gave us guns and badges. SEC investigators still lack these hallmarks of criminal law enforcement, but the agency’s civil investigative process has recently taken on the look and feel of a criminal investigation like never before. That’s no accident.
Last year, amid public outrage over the SEC’s failure to catch Bernard Madoff, one of its commissioners spoke out in favor of giving the regulator unprecedented criminal prosecutorial powers to supplement its historical ability to file civil lawsuits and administrative proceedings. That idea garnered little support. But the SEC then appointed Robert Khuzami, a top-notch former federal prosecutor, as its new enforcement chief. Khuzami, in turn, has filled many senior enforcement posts with fellow veterans of the federal criminal process rather than career SEC staff.
Beginning last summer, the SEC also began a series of internal changes ostensibly designed to streamline investigations by pushing significant decision-making authority further down the chain of command. These changes have included delegating to enforcement staff unprecedented authority to begin formal investigations and issue subpoenas without any prior approval by the regulator’s presidentially appointed commissioners. This heightened emphasis on swift action might explain the SEC’s reported failure to give Goldman Sachs the customary opportunity to explore settlement before filing recent fraud charges against the firm.
Earlier this year, the SEC flattened out management of its enforcement division by removing the entire first line of day- to-day supervisors of investigations. It also formed five specialized units so that many enforcement staff investigators will now focus exclusively on only one type of case. In addition, the SEC recently announced new incentives for investigative subjects to cooperate with agency probes and to turn in their cohorts. Companies that do so can be rewarded with deferred prosecution agreements or even non-prosecution agreements, tools well known in the criminal process but never before used in SEC investigations.
Congress also may jump on the bandwagon. Legislation passed by the House of Representatives in December would grant the SEC several quasi-criminal enforcement tools, including broad new power to impose hefty fines without court approval and the unprecedented ability to obtain secret grand jury materials from criminal prosecutors. These tools, however, are not in the current version of the Senate’s financial reform legislation.
These SEC initiatives and legislative proposals appear clearly designed to bring the SEC’s enforcement processes more in line with those of a criminal prosecutor’s office, and so far they have received a mostly enthusiastic reception. After all, the conventional wisdom seems to be, isn’t it about time the SEC started getting tough on those greedy executives and treating them more like common thieves? Well, actually no.
Contrary to the impression fueled by recent media coverage and congressional scrutiny of the SEC’s work, most subjects of its investigations bear little resemblance to common thieves. In fact, many are never charged with any wrongdoing at all, much less felonies, and the vast majority aren’t accused of anything close to criminal misconduct. For every Madoff the regulator investigates, dozens of generally law-abiding companies and executives find themselves caught up in its investigative process. Those ultimately accused are typically brought before civil or administrative courts, usually without any hint of criminal wrongdoing. The offenses are often quite serious, but they are not felonies.
Yet for most people the SEC investigates, the mere suspicion of even a minor regulatory infraction can be devastating to their careers and reputations. That’s why the SEC’s investigative process historically has been a deliberate and methodical one, devoid of the urgency needed to stop and prosecute felony crimes. The SEC’s principal mandate is protection of investors, not punishment of wrongdoers --although punishment can sometimes be an important means to protecting investors.
To be sure, the SEC process can be maddeningly slow and bureaucratic at times, particularly from the perspective of staff level investigators and those who consider themselves victims of the conduct under scrutiny. But it is also widely regarded as one of the fairest law enforcement processes around, and one of those most likely to culminate in a just and measured outcome. Unlike federal prosecutors, who are fully accountable to the attorney general and the president, SEC attorneys work for an independent agency whose commissioners, once appointed by the president, are not removable at will.
For this reason, the SEC properly exercises only limited civil powers. For the relatively few SEC investigative subjects who engage in criminal misconduct, plenty of talented executive branch prosecutors stand willing and able to prosecute them in the conventional way. The Constitution demands nothing less. One thing hasn’t changed since I was at the SEC -- its investigators still don’t need guns and badges to accomplish their mission.
Russell G. Ryan was an assistant director of the SEC’s division of enforcement from 2000 to 2004.
ACA became Wall Street's trash can, now haunts Goldman
by Dan Wilchins
It became Wall Street's trash can.
ACA Capital Holdings Inc, one of the investors that the U.S. government says was duped by Goldman Sachs, was a bond insurer best known for doing deals that few other companies would touch. The company, which guaranteed debt and managed portfolios of complicated instruments known as asset-backed securities, collapsed and had to be taken over by state regulators in late 2007. "It was widely believed, and for very good reason, that ACA was not very sophisticated," said Arturo Cifuentes, a former structured finance banker at small broker dealer R.W. Pressprich & Co.
ACA is not accused of wrongdoing, and was hardly the only company that misgauged complicated securities in the middle of the decade. Even investors and managers that seemed smart in mid-2007 turned out later to have been dead wrong. And not everyone in the marketplace viewed ACA as unsophisticated. One trader said he worked with ACA earlier this decade and found them to be careful and diligent. But many traders said it was an open secret that ACA would consider deals that few others would take.
"They'd say 'yes' to pretty much everyone who asked them to dance," said one Wall Street professional who did business with ACA. Another veteran trader at an investment firm said the company was not looking at the right issues when analyzing structured credit. "The only thing missing there was the clown car," he said. A spokesman for Goldman said ACA was an experienced manager and had every incentive to pick securities well in the transaction in question.
ACA made mistakes that hastened its demise, traders and former employees said, including pursuing relentless growth by diving into risky securities and hiring as few people as possible to analyze them. One of ACA's big mistakes was viewing credit risk as something that could be analyzed using black-and-white rules, instead of independent thinking, Cifuentes said. Other bond insurers made that same mistake, he added. But because ACA had a lower credit rating than many of its competitors, it had to take more risk to win business, traders noted.
Hat, Boots, Vest
The lower credit rating was by design. ACA originally staked out its niche as a bond insurer that focused on weaker credits. ACA was founded in New York in 1997 by Russ Fraser, a former executive at companies including Standard & Poor's, bond rating company Ambac, and ratings agency Fitch. Fraser was famous for his passion for the West, and would often show up to work in a cowboy hat, a leather vest, and boots, former employees said. He spent weekends on his cattle and dude ranch in Wyoming.
Fraser focused on guaranteeing debt from municipal utilities, museums and other tax-free bond issuers that had relatively weak credit ratings. ACA had a "single A" credit rating, far below the "triple A" rating of its competitors. But that meant ACA's guarantee was cheaper, a selling point for its clients. ACA could insure weaker municipal debt without much concern about it actually defaulting. Because of the tougher standards that ratings agencies used for tax-free issuers, municipal credits defaulted much less often than their ratings implied. And if ACA was particularly concerned about the issuer, it could negotiate to reduce its risk by, for example, demanding collateral.
Those deals could translate into solid profits for ACA, but the company saw limited growth potential in that part of the market, said Michael Satz, who was chief executive of ACA in the first half of this decade, after Fraser left the company. So ACA took its credit expertise into the land of corporate credit, focusing on niche deals in structured credit, like small pieces of CDOs. "We limited our exposure and got fees, and in the worst case we would lose a few million dollars," Satz said.
In 2004, Satz was preparing to take the company public, but the deal was scuttled when lead underwriter JPMorgan Chase & Co found that he had tax issues from a prior job. Bear Stearns stepped in and gave more capital to ACA. Satz was pushed out, and Alan Roseman, a bond insurance veteran, became CEO. To former employees and people who traded with the company, that was the beginning of the end.
Roseman sought relentless growth for ACA. He was first readying the insurer to go public, which it did in 2006, and then he was trying to generate the kind of growth that would make shareholders happy, former employees said. Roseman did not return calls to his home and cell phone. He was particularly keen for the company to dive into the branch of structured finance that would prove the most toxic: consumer debt that had been packaged into bonds and then repackaged into CDOs. "There was an aggressive push for business in structured finance, which had the most sizzle," said one former employee.
ACA had at least two ways to earns fees from those deals: by guaranteeing some of the risk in the deals, and by picking portfolios of securities to be packaged into CDOs. The structured finance business mushroomed. On the guarantee side, it had about $14.6 billion of exposure at the end of 2005. By the fall of 2007, that figure was closer to $70 billion. But growth came at a price. Traders that worked with ACA noted a real difference in the kinds of deals it was willing to do as the credit bubble inflated further.
Keeping up with rapid growth is tough for any institution, and ACA may not have invested enough in personnel, a former employee said. He estimated that the company had about 15 to 20 professionals working in structured finance by early 2007, and needed at least 25. Several traders noted that even firms that did invest heavily in hiring professionals to deal with structured finance lost a good deal of money in the area.
Easy To Deal With
Goldman Sachs, which is accused by the Securities and Exchange Commission of failing to give crucial information to investors in a CDO, seems to have known that ACA wasn't the most stringent partner to work with. ACA was nominally in charge of picking the subprime mortgage bonds that were packaged into the CDO, but hedge fund manager Paulson & Co suggested many of the securities, according to the SEC's complaint. ACA did not know that Paulson was shorting the securities, the SEC said. ACA also indirectly took risk from the deal.
Goldman has said it never misled ACA, and to the extent ACA was misled, it was not intentional. According to an email exchange released by the Senate Permanent Subcommittee on Investigations, bond trader Fabrice Tourre and his colleagues at Goldman mooted a number of possible managers to pick securities. Tourre suggested brainstorming for managers that were "flexible" regarding picking securities. As colleagues came up with ideas, they continually mentioned that particular managers were "easy" to work with. The names of the asset managers were redacted in the released email, but in the end, Goldman picked ACA.
Michael DuVally, a spokesman for Goldman Sachs, said that ACA was an independent and experienced portfolio manager, and was the largest investor in the deal in question, and "had every incentive to select appropriate securities." For much of the decade, a number of Wall Street firms refused to do business with ACA directly but as the credit crunch intensified in 2007, some additional banks started turning a blind eye to ACA's obvious problems.
Merrill Lynch offloaded billions of dollars of exposure onto the company. Buying insurance on bad assets allowed banks to avoid writing them down. "Merrill was giving risk to everyone that would take it, and by then not many were," said one CDO professional. In the end, the toxic garbage that it took on from Wall Street overwhelmed ACA. In December 2007, it was all over for ACA. Maryland's insurance regulator took significant control of its bond insurance unit, and the company is now winding down its business.
FDIC Shuts Seven More Banks at a Cost of Over $7 Billion
by Douglas McIntyre
The Federal Deposit Insurance Corporation closed seven more banks on Apr. 30, bringing the total to 64 for the year. The day was particularly expensive, costing the agency just over $7 billion. According to the FDIC website, the banks were Frontier Bank (Everett, Wash.), National Banks (Butler, Mo.), Champion Bank, (Creve Coeur, Mo.), CF Bancorp (Port Huron, Mich.), Westernbank Puerto Rico (Mayaquez, Puerto Rico), R-G Premier Bank of Puerto Rico (Hato Rey, Puerto Rico), and Eurobank (San Juan, Puerto Rico). Frontier Bank's shuttering will be particularly expensive, costing the insurance fund that protects bank depositors $1.37 billion.
The health of the FDIC's funds depend on the pace of bank closures, which will certainly top 200 this year. If the agency runs out of money, it has nowhere to turn to but the U.S. Treasury -- another way of saying taxpayers will be on the hook. Last November, the agency brought in $45 billion by having the banks under its umbrella pay their fees through 2012. At that time, the FDIC said it was about to run out of money -- the $50 billion it had before the crisis began was gone.
The bank closures are a repercussion of the wave of losses that hit large banks, which were aided by the Troubled Asset Relief Program fund. Most of the banks being closed now are medium-size or small banks that have exposure to commercial and residential mortgages. Many of the properties they made loans for are going into default, and this damaging process is expected to continue. The $45 billion seemed like a lot when the FDIC raised it. It doesn't seem very much now.
Tough times force US cities to consider going bankrupt
by Nicole Bullock
Council meetings in Harrisburg, the capital of Pennsylvania, have debated issues ranging from snow removal and rubbish collection to a rise in dog fighting, but a meeting this week was particularly unusual. In a sign of the tough times, officials called in experts to discuss the pros and cons of going bankrupt. "There is no good option," Dan Miller, Harrisburg city controller, told the city's administration committee. Mr Miller and some members of the committee advocated exploring bankruptcy as a way to get out from under its debts.
Other officials at the three-hour meeting worried about the ramifications. Bankruptcy has never been used widely by municipal authorities so they have few guidelines. But with cities, towns and counties across the US hard hit by the recession, local officials, investors and analysts are questioning whether bankruptcy could become more common. The debate stretches from city halls to Wall Street, and the Securities Industry and Financial Markets Association (Sifma) will have its own public airing on the topic at a conference today in Manhattan.
In 2009 alone, corporations filed more than 11,000 Chapter 11 bankruptcy proceedings. Since 1937 there have been a little more than 600 cases of Chapter 9, the part of the federal bankruptcy code applicable to municipalities, said James Spiotto, a partner at the Chapman and Cutler law firm. Probably the most high- profile case came in 1994 with Orange County, California. Since the downturn hit, the city of Vallejo, California, went bankrupt in 2008. Last year, filings more than doubled from the previous year but still only came to 10.
Among the larger cities, Harrisburg and Detroit have raised the idea, without formal plans. "Most municipal bankruptcies have been special districts with recourse to only one source of revenue and not large cities that are more diverse and have some sway to get investors to forbear," said Matt Fabian, managing director of Municipal Market Advisors. The belief that municipalities rarely go bankrupt, or even default, is the bedrock of the $2,800bn (€2,100bn, £1,825bn) municipal bond market where they raise money at relatively low cost for public projects. If filings increase, market experts expect them to be mostly small, special cases.
They have long argued that the fear of higher borrowing rates associated with bankruptcy is severe enough to discourage most. But with cities such as Harrisburg considering it, these long-standing beliefs are being challenged. ". . . The more bankruptcy is publicly discussed as an option for financial relief, the more its tarnish wears off, increasing the likelihood of its actual use," Fitch Ratings warned in a report earlier this year. The biggest impediment, however, could be that the process is much more prohibitive than for companies.
More Than a Million in U.S. May Lose Even Emergency Jobless Benefits
by Brian Faler
Since the U.S. recession began in December 2007, Congress has extended the length of unemployment benefits for the jobless three times. Now, the lawmakers may have reached their limit. They are quietly drawing the line at 99 weeks of aid, a mark that hundreds of thousands of Americans have already reached. In coming months, the number of those who will receive their final government check is projected to top 1 million.
It’s a deadline that has rarely been mentioned in recent debates over jobless benefits, in which Republicans have delayed aid because of cost concerns. The deadline hasn’t been lost on Teauna Stephney, a 39-year-old single mother from Bothell, Washington, who said she could become homeless once her $407 weekly checks stop in June. "What are people like me supposed to do?” said Stephney, who said almost two years of benefits haven’t proved long enough for her to find work after she lost her last job in August 2008. Referring to lawmakers, she said, “I would like them to come and talk to me and spend a day in my shoes.”
Democrats who have pushed through the past extensions agree there’s insufficient backing to go beyond 99 weeks, largely because of mounting concern over the federal deficit, projected to reach $1.5 trillion this year. “You can’t go on forever,” said Senate Finance Committee Chairman Max Baucus, of Montana, whose panel oversees the benefits program. “I think 99 weeks is sufficient,” he said. “There’s just been no discussion to go beyond that,” said Senator Byron Dorgan, a North Dakota Democrat.
Some Republicans say cutting off aid will spur people to find work. “We have study after study that shows people are more anxious to get a job after they run out of benefits,” said Representative John Linder of Georgia, the top Republican on the Ways and Means subcommittee with jurisdiction over the unemployment program. “Continuing to extend this isn’t helping them or us.” Allowing the ranks of those who lose their aid to swell carries risks for Democrats in November’s elections.
“They’re damned if they do and damned if they don’t,” said Stuart Rothenberg, publisher of the Rothenberg Political Report. Voters are “sensitive these days to spending and deficit issues and yet there are going to be people who need help, and if the administration ignores them, they’ll look rather callous.” Baucus said extension legislation would fail in the Senate because of both the deficit and the negative “atmospherics” of lengthening the weeks of aid into triple digits. “The best thing to do is get this economy turned around” to create jobs, said Baucus.
Unemployment aid has become one of the federal budget’s fastest-growing components, with costs this year likely to reach $200 billion. That’s six times what was typically spent before the recession. Since the recession began, aid extensions added 53 weeks of assistance to the 46 weeks that had been in place. About 11 million Americans, roughly 70 percent of the nation’s jobless, in March received unemployment checks averaging $320 per week. The challenge for lawmakers is that while benefits have reached record lengths, so has long-term unemployment. According to the Bureau of Labor Statistics, 44 percent of the jobless have been out of work for at least six months, the biggest share since the government began keeping track in 1948.
About 3.4 million Americans -- approximately the population of Connecticut -- have been out of work for more than a year, according to a study by the Pew Fiscal Analysis Initiative. The states, not the federal government, track how many exhaust their unemployment benefits, said U.S. Labor Department spokesman Matthew Wald. Interviews with state officials found that in New York, 57,000 people have received their last check. In Florida, 130,000 are no longer eligible as are about 30,000 Ohioans. Those numbers will grow, according to Goldman Sachs Group Inc., which projects that more than 400,000 may soon begin losing benefits every month.
“The political climate is not as conducive to additional expansions as it had been last year,” a Goldman analysis said. “The result is likely to be a greater share of unemployed workers not receiving unemployment compensation.”
Democrats have struggled to pass legislation just to maintain current benefits over Republican objections about adding to the deficit. Benefits have been interrupted twice because of efforts by Republican Senators Jim Bunning, of Kentucky, and Tom Coburn, of Oklahoma. “We’re trying to extend unemployment assistance as it currently exists and we’re having a devil of a time getting that done,” said Dorgan. President Barack Obama signed into law this month a measure extending until June the date by which individuals can qualify for 99 weeks of aid, a move designed to buy lawmakers time while negotiating a bill that would continue such eligibility through year’s end.
That won’t help people like Stephney. And Representative Jim McDermott, a Washington Democrat who supports another extension of benefits, said there’s so little support for the idea that he hasn’t bothered to introduce legislation. “What happens to these families when they have no money for food, no money for their rent and no money for their health care?” said McDermott. “It’s a problem that nobody around here wants to talk about.”
GDP rise not enough to make dent in jobless rate
by Jeannine Aversa
The numbers would be excellent in normal times, but for a country recovering from deep recession, they're not enough. Spending by consumers rose by the fastest pace in three years, helping the economy grow at an annual rate of 3.2 percent in the first quarter of the year, the Commerce Department said Friday. It marked the third straight quarterly gain as the nation heals from the longest and deepest recession since the 1930s. That has not been enough, however, to ignite a recovery capable of driving down the jobless rate, which has been stuck at 9.7 percent since January and is not expected to dip significantly for months.
"The recovery is slowly gaining traction, but it's not growing fast enough now to bring down unemployment and let ordinary Americans feel like they are finally off and running," said Mark Zandi, chief economist at Moody's Analytics. Economists say it takes about 3 percent growth in gross domestic product to create enough jobs just to keep up with population growth. Growth would have to be about 5 percent for a full year just to drive the unemployment rate down by 1 percentage point.
After the last severe recession in the early 1980s, GDP grew at an annual rate of 7 percent to 9 percent for five straight quarters, and the unemployment rate plunged from 10.8 percent to 7.2 percent in 18 months.
Economists don't see anything like that happening this year or the next. In fact, growth in the first quarter was weaker than in the fourth quarter of last year, when the economy grew at a 5.6 percent rate. Facing the prospect of 9 percent unemployment leading into the November congressional elections, President Barack Obama called the GDP report an "important milepost on the road to recovery" but acknowledged that the economy must create more jobs.
Consumers increased their spending at an annual rate of 3.6 percent in the first quarter. It was the strongest showing since early 2007 — before the Great Recession. And it marked a big improvement from the fourth quarter, when spending grew at a lackluster 1.6 percent pace. Americans spent more on home furnishings and household appliances, recreational goods and vehicles and clothing. They also spent more at bars and restaurants. Analysts, however, say consumers will be wary of stepping up spending much further. The high unemployment rate, sluggish wage growth and a reluctance or inability to borrow probably will limit spending, they say.
Another report Friday highlighted one of those headwinds: low wage gains for workers. Wages and salaries rose just 0.4 percent, after a 0.5 percent gain in the fourth quarter of last year. Just 21 percent of Americans consider the economy to be in good condition, according to an Associated Press-GfK Poll conducted April 7-12. Robert Harris, a 33-year-old father of four in Utah, said he's spending only marginally more these days. He just bought a new cell phone and is throwing a few more items in the grocery cart. He's spending a tad more on birthday gifts. Still, he isn't willing to go on any shopping sprees, even though he and his wife have secure jobs in an art department at a marketing company.
What would it take for consumers to boost their spending much higher and help catapult economic growth? Analysts say employers would need more confidence that sales will rise enough for them to ramp up hiring and raise workers' pay. Shoppers need to be able and willing to borrow more. And Americans need to rebuild more of their household wealth, especially equity lost from home values that tanked during the recession. Few people expect any of those things to happen quickly. Many economists think it will take until at least the middle of the decade to lower the unemployment rate to a more normal 5.5 percent to 6 percent range. "How will consumers behave in terms of spending in the coming months? On a scale of one to 10, I'd put it at a four," said Richard DeKaser, president of Woodley Park Research.
DeKaser and others predict increases in consumer spending will slow to a rate of around 3 percent in the second and third quarters. That's respectable. But it falls far short of how much consumers spent coming out of the deep recession of 1981-82. The first quarter's reading on GDP was a tad shy of the 3.4 percent growth rate economists were forecasting. GDP measures the value of all goods and services — from machinery to manicures — produced within the United States. It is the best gauge of the nation's economic health. Companies helped boost GDP by restocking inventories shrunken during the recession. Their first-quarter spending on equipment and software rose at a brisk 13.4 percent pace, after an even bigger 19 percent growth rate in the fourth quarter of 2009.
Exports grew at a slower pace in the first quarter. Imports rose much faster — reflecting stronger demand by U.S. consumers. That meant the nation's trade deficit dragged on GDP in the first quarter. Slower export growth probably reflects less demand coming from trading partners in Europe because of the debt crisis there, analysts say. Troubles in the real estate market slowed economic activity. Builders trimmed spending on housing projects after two quarterly gains. Spending on commercial real estate plunged at a 14 percent annual rate, the seventh straight decline. The federal government increased spending at a 1.4 percent pace, but state and local governments continued to trim, a trend that analysts expect will continue for years.
Despite its weaknesses, the U.S. economy appears to have turned a corner. Employers are creating jobs again — a net total of 162,000 in March, the most in three years. Manufacturers are boosting production. Consumer confidence is higher. And a rising number of companies — from Ford, Caterpillar and Whirlpool to UPS, Estee Lauder and Royal Caribbean Cruises — are seeing profits grow. General Electric says the "clouds are breaking" after having suffered one of its worst years in 2009. Economists in a recent AP Economy Survey predict the economy will gain some speed, growing at a rate of 3.7 percent in the April-to-June quarter.
Nariman Behravesh, chief economist at IHS Global Insight, bumped up his second-quarter forecast to a pace between 4 and 4.5 percent, up from 3.7 percent. Zandi, another survey participant, is sticking with his forecast of second-quarter growth slowing to around 2.5 percent. For 2010 as a whole, economists in the AP survey predict the economy will grow 3.1 percent. That's an improvement from the 2.4 percent decline in 2009, the worst since 1946. But much stronger growth in the 5 percent range is needed to drive down the unemployment rate.
Obama Prods Economic Team to Stay
by Jonathan Weisman
President Barack Obama, trying to head off a staff exodus after the November elections, has been pressing members of his economic team to stay with his administration until the economy is on a stronger footing, Democratic officials said.
Mr. Obama's effort is unusual. Most presidents fully expect members of their economic teams to leave after the first two years of their administrations, prompted by the grueling intensity of life in the White House and the allure of the more lucrative private sector.
Despite Mr. Obama's efforts, some members of the team, such as White House Budget Director Peter Orszag and Council of Economic Advisers Chairwoman Christina Romer, are still eying the exits.
But administration officials say the difficult economic climate means the White House must press for continuity. The recovery is still shaky, with unemployment at 9.7%. And pivotal questions on the budget deficit and tax code have yet to be answered.
White House Chief of Staff Rahm Emanuel said the team has worked well together, but he emphasized there is no begging going on. "The principal of the economic team is the president of the United States," he said. "It is those guys who assist him."
But, another White House official said, "The president desires to have continuity in his economic policy. This is not the time to have turnover."
Amid multiple economic crises and an ambitious legislative agenda, the opening months of the Obama White House have been particularly difficult, administration officials say.
The president's preference for debate and multiple power centers instead of a central policy clearinghouse has created "a very difficult environment," one senior Democrat said.
Mr. Obama, speaking to reporters aboard Air Force One Wednesday night, said, "We've gone through a very tough year, and I've been driving Congress pretty hard."
For now, two top economic-team members once seen as on their way out appear to be staying put.
The position of Treasury Secretary Timothy Geithner, who has resisted pressure from critics to step down for his early handling of the financial crisis, has been strengthened by his management of the financial-regulation overhaul now being debated in Congress. National Economic Council Director Lawrence Summers, who also absorbed heavy criticism and was eager to rejoin the private sector, will remain to navigate a brewing tax fight, officials said.
Much of the doubt has centered on Mr. Orszag, who Mr. Obama personally called into the Oval Office and asked to stay in April. After four years in senior government posts, two as director of the Congressional Budget Office, Mr. Orszag has suggested that he wouldn't diverge from the traditional term of a White House budget director—generally about 18 months. He contends that he already has had two successes: passage of the economic-stimulus package and the sweeping health-care law.
But a fall departure would be difficult since that would be when the White House begins to assemble its budget proposal for the 2012 fiscal year.
White House budget-office spokesman Ken Baer said Thursday Mr. Orszag has no plans to leave. Other administration officials say a final decision hasn't been reached.
Gene Sperling, a counselor to Mr. Geithner, has completed the vetting process to become deputy budget director but hasn't made the move, in part because any new director would want to select a deputy, one official said.
Ms. Romer has said she is staying at least until the next Economic Report of the President is complete next February. Heads of the Council of Economic Advisers rarely stay beyond two years.
The nomination Thursday of San Francisco Federal Reserve Bank President Janet Yellen to be vice chairwoman of the Federal Reserve Board has opened a post in the Bay Area, a position Ms. Romer isn in a leading position to fill. The post would keep her plugged into Washington policy making, which confidantes say she has enjoyed.
It seems unlikely Mr. Obama will avoid any departures. If Republicans win control of either congressional chamber this fall, White House officials worry they could make life difficult for administration aides with GOP subpoena power, another factor encouraging an exodus.
Meanwhile, Austan Goolsbee, a member of the Council of Economic Advisers and director of the President's Economic Recovery Advisory Board, is deciding now whether to return to the University of Chicago for the coming academic year, White House officials said.
The president's big domestic-policy fights will likely blossom after the November election.
If Congress doesn't act, President George W. Bush's tax cuts will expire Jan. 1, 2011, raising income, capital gains, dividend and estate taxes. Mr. Summers helped formulate Obama campaign tax proposals that would allow some Bush tax cuts to expire, preserve those that benefit families with incomes under $250,000 and modify others.
The president's federal debt commission is supposed to complete its work Dec. 1. If 14 of the panel's 18 members can reach agreement on proposals to cut spending and raise taxes, Democratic leaders have promised a vote on the recommendations before the end of the year. If that does not happen, the budget deficit will be one of the biggest economic challenges facing Mr. Obama for the remainder of his term.
Currencies: Carried away
by Gillian Tett and Peter Garnham
Adair Turner is at it again. Having criticised numerous practices in the financial world – among them “socially useless” banks and crazed innovators – Britain’s most senior regulator has a new target in his sights: currency speculators. This month, Lord Turner solemnly told a group of economists assembled in the Great Hall of King’s College, Cambridge that he was alarmed by the recent explosive growth in foreign exchange dealing. While some of this expansion helped lubricate global trade, said the chairman of the Financial Services Authority, most stemmed from speculative activities such as the “carry trade” – the practice of borrowing cheaply in one currency to invest in another. “Foreign exchange carry trades are, as far as I can see, of zero value and potentially destabilising,” he added, indicating that he would like to curb a business currently thought to have as much as $1,000bn (£655bn, €755bn) in positions outstanding in the market.
Since the world abandoned the Bretton Woods system of fixed exchange rates almost 40 years ago, most western policy-makers have assumed that vibrant, free foreign exchange markets are a good thing. But Lord Turner is not alone in questioning the value of all this activity. “The prosperity of the postwar era owned much to Bretton Woods ... we need a new Bretton Woods,” Nicolas Sarkozy, the French president, told this year’s World Economic Forum in Davos. “We cannot preach free trade and tolerate monetary dumping.” Such ideas provoke horror or derision among financiers, many of whom have come to view the carry trade as a cornerstone of their strategies. Sophisticated hedge funds, for example, hop across borders with ease, using cheap yen and other currencies to buy higher-yielding assets. Even retail investors have been in on the act, with many in eastern Europe having borrowed heavily in currencies with low interest rates, such as the Swiss franc, to buy houses.
Currency speculators insist that this is needed to help rebalance the global economy. If investors were not free to trade in different currencies and use different ways of funding themselves, they ask, how would countries such as the US ever manage to fund its vast budget deficit? The carry trade has been “one of the principal methods in which debtor nations have been able to recycle their deficits over the past 40 years”, says Neil Record of Record Currency Management, a specialist adviser. “Surplus countries have historically offered their citizens lower short-term interest rates than deficit countries, and this has encouraged these citizens to seek higher returns – and therefore investment risk – elsewhere.” Some of Lord Turner’s fellow policy-makers also suspect it would be hard to clamp down on the carry trade effectively – if indeed a pro-market western government wished to do so. “It is not easy to define a carry trade, or even to tell how large it is,” says one senior European regulator. “This is not a very practical idea.”
Nevertheless, even if his and Mr Sarkozy’s comments are controversial, it could be a politically astute moment to start a new debate about the carry trade. The issue of foreign exchange speculation has not dominated the political agenda in recent years – partly because the foreign exchange markets have been relatively quiet. But after central banks loosened monetary policy to tackle the global financial crisis, some investors have used this cheap, short-term funding to make big bets on higher-yielding assets, ranging from Brazilian shares to American mortgage bonds. “It appears to us as if bail-outs and other government and central bank stimulus policies have mainly succeeded in restoring many of the bubble elements that were in financial markets in 2006-07,” says Timothy Lee of Pi Economics, a consultancy.
However, the Federal Reserve and European Central Bank are now signalling that they hope to tighten policy soon, potentially undercutting the carry trade. Publicly, central bankers say they will pursue these so-called “exit strategies” very cautiously; in practice, however, some economists fear that these actions could create new market shocks. By raising interest rates too aggressively, central banks could not only derail the global recovery, but also reduce the attractiveness of selling their currency as a funding vehicle for investing in asset markets across the globe. Thus they risk delivering a double dose of anxiety for financial markets. As a result, the question that policy-makers are trying to assess is not merely the absolute size of the carry trade but also the degree to which any sudden reversal could hurt financial investors – if not the system as a whole. “Unfortunately, when you look at the world today, many of the imbalances that caused the last crisis are still there,” says one senior western central banker. “That means there is still a real risk of more dislocation. The carry trade issue is part of that.”
Certainly, recent history suggests that carry trades can produce unpleasant surprises. Take the yen. In the 1990s, following the collapse of the Japanese property bubble, the Bank of Japan slashed interest rates to a level well below the rest of the developed world. By the middle of that decade, the gap between medium-term US and Japanese rates was 4 percentage points. That prompted both western hedge funds and Japanese domestic investors to borrow heavily in yen to place bets in higher-yielding currencies ranging from the Italian lira to the New Zealand dollar. As a result, the value of the yen fell and the price of those other assets soared, since investors were essentially selling the Japanese currency to buy other assets. In 1997, however, those trading strategies started to unravel when the Asian financial crisis tipped markets into a panic. Then, after Russia defaulted the following year, hedge funds such as Long Term Capital Management were suddenly forced to cut their positions. As investors unwound their carry trades, currencies gyrated wildly, with the yen appreciating in value by 15 per cent over just two days in October 1998 – causing huge losses for investors. For LTCM it brought implosion.
After that bruising experience, many currency speculators were happy to sit on the sidelines for a while. But by the middle of the last decade, the carry trade returned with a vengeance. The low level of Japanese rates prompted investors again to borrow in yen in order to purchase high-yielding assets such as New Zealand bonds. And, once more, the value of those currencies and assets soared. (Indeed, by 2006, the New Zealand government was so alarmed by the appreciation of its currency that it begged Japanese investors to stop buying kiwi bonds.) Meanwhile, investors in Europe and the US also borrowed heavily in currencies such as the Swiss franc or the euro to buy eastern European assets or to invest in countries such as Iceland. Yet in 2007 – as in 1997 – many of these carry trades were dramatically unwound, when the onset of the subprime crisis forced banks and hedge funds to cut their positions. The yen strengthened; currencies such as the Icelandic krona, New Zealand dollar and Brazilian real fell. Disastrously, this sudden carry trade unwinding prompted investors to flee from assets in countries such as Iceland, where it triggered a full-blown crisis.
These days, to the relief of many policy-makers, there is no sign that the yen carry trade is about to re?appear. Mr Lee of Pi Economics estimates that the bulk of the yen carry trade that built up between 2004 and 2007, and peaked at $1,000bn, has been unwound. That is partly because the cost of borrowing yen has moved into line with other currencies: last summer, the three-month rate for borrowing yen in the London interbank market rose above similar dollar costs, for the first time for several decades. This made the dollar a more attractive currency than the yen in which to fund carry trades. But that does not mean that the carry trade is in decline, just that investors have switched from funding deals in yen to selling other currencies to finance their investments. Indeed, by late last year the International Monetary Fund was observing that “there are indications that the US dollar is now serving as the funding currency for carry trades”. Mr Lee thinks many of the investors he tracks have switched out of yen carry trades into the dollar in the past couple of years. He calculates that there are some $500bn-$750bn of dollar-based carry trades in the global financial system, plus $250bn-odd funded in other currencies.
Others have even bigger estimates. “To me the big risk this year is the dollar carry trade,” Zhu Min, deputy governor of the People’s Bank of China, said recently, adding that there was now a real risk of a violent unwinding. “It is a massive issue. Estimates are that the dollar carry trade is $1,500bn – which is much bigger than Japan’s carry trade was.” In the foreign exchange markets, however, some analysts argue that there are already signs that investors are preparing themselves for the prospect of higher US interest rates – and may even be unwinding some of their carry trade positions in the dollar as a result. With the dollar having already appreciated this year, Mansoor Mohi-uddin, managing director of foreign exchange strategy at UBS, thinks the US unit is moving from being a “funding” – or “safe haven” – currency to become one that investors use if they want to chase higher returns as a result of economic growth. “The dollar [is] starting to behave as a growth currency,” he says, noting that “the Federal Reserve is likely to be the first of the major central banks to raise interest rates this year”.
If this process of adjustment does not proceed smoothly – as people such as Mr Zhu fear – it could spark a great deal more political debate. In any event, the French will next year chair the Group of 20 leading industrialised and developing nations and Mr Sarkozy’s remarks show he is determined to open discussions about a new monetary system. Yet the French have broached similar ideas before without any impact, while even men such as Lord Turner know that calling for a rethink of the carry trade is too radical for most policymakers. “There are a range of ideas that need to be taken out of the ‘index of forbidden thoughts’,” he recently declared. But if the past two years have shown anything, it is that when a crisis strikes, ideas that used to seem unthinkable can suddenly enter the mainstream. Right now, all might seem relatively quiet on the foreign exchange front. But investors and politicians alike could do well to watch the carry trade as closely as they can, even – or especially – if no one knows how large it might be.
Greece Faces 'Unprecedented' Cuts as $159B Rescue Nears
by Jonathan Stearns and Maria Petrakis
Greek Finance Minister George Papaconstantinou said Greece faces “unprecedented” budget cuts as the euro region and International Monetary Fund near approval of a 120 billion-euro ($159 billion) bailout for the debt- stricken nation. Greece must brace itself for “very demanding tasks,” Papaconstantinou said yesterday in Athens, where the government is wrapping up talks with the IMF and EU on conditions for the three-year loans. “We are at a critical point in the history of our country.”
European finance ministers plan to meet tomorrow to approve their share of the bailout meant to stop the biggest crisis in the euro’s 11-year history. While Greek stocks and bonds rebounded after German Chancellor Angela Merkel said April 28 the EU must speed up its response, the crisis rippled through the euro area. Standard & Poor’s downgraded Greece to junk this week and followed with cuts to Portugal and Spain. The Greek government may agree in the face of public protests to budget cuts worth 24 billion euros, or around 10 percent of gross domestic product, as a condition for the aid package, Greece’s NET Radio said. Measures may include a three- year wage freeze for public workers and the elimination of two of their 14 annual salary payments, the ADEDY union said.
“Huge doubts remain about the ability of the Greek government to implement these policy changes amid mounting signs of discontent within the population,” Michael Saunders and other economists at Citigroup Inc. said in an e-mailed note. “Even in the event of a successful implementation of the measures, risks remain of a vicious spiral between tighter fiscal policy and collapsing real growth.” Details of the loan conditions will emerge when the Athens talks conclude. Expectations the negotiations would end today prompted Luxembourg Prime Minister Jean-Claude Juncker, who leads the group of euro-area finance ministers, to convene the meeting to ratify the agreement at 4 p.m. in Brussels tomorrow.
The euro area aims to contribute two-thirds of the total aid for Greece and disbursing that share, including as much as 30 billion euros for 2010, requires the unanimous approval of the region’s national governments. Finance ministers will ratify at least the first year of contributions tomorrow. The pending Greek wage cuts will overshadow today’s annual Labor Day celebrations in Athens, usually marked by rallies and picnics, which unions called on Greeks to join before the “coming storm.” The slogan is: “The Croesus-es should pay for the crisis,” a reference to the ancient king renowned for his wealth.
Stocks and bonds fell this week after Merkel’s initial reluctance to approve disbursing funds to Greece stoked concerns about a default. The extra yield that investors demand to hold Greek debt over bunds exceeded 800 basis points on April 28. The spreads on Portuguese, Spanish and Irish debt also jumped, with the premium on Portugal’s 10-year bonds rising as high as 299 basis points on April 28. Signs of a renewed drive to tackle Greece’s troubles then helped spark a recovery. European Central Bank President Jean- Claude Trichet on April 29 said policy makers must create a “sense of direction” to help overcome the fiscal crisis.
Greece’s ASE benchmark general index rose 2.2 percent yesterday, extending a 7 percent gain the previous day. The yield on Greek 10-year government bonds, which surged to 11.406 percent on April 28, was at 9.45 percent. Papandreou is caught between investors, who want faster deficit cuts, and voters and unions, who are already chafing at existing austerity measures. Elected in October on pledges to raise wages for public workers, Papandreou has been forced to cut salaries, curb spending and increase taxes to reduce a deficit that was more than four times the EU limit last year.
Other deficit-cutting steps include increasing sales tax and raising the cap on the number of workers who can be fired to 4 percent from 2 percent, Kathimerini newspaper reported, without saying where it got the information.
Greek Wealth Is Everywhere but Tax Forms
by Suzanne Daley
In the wealthy, northern suburbs of [Athens], where summer temperatures often hit the high 90s, just 324 residents checked the box on their tax returns admitting that they owned pools. So tax investigators studied satellite photos of the area — a sprawling collection of expensive villas tucked behind tall gates — and came back with a decidedly different number: 16,974 pools. That kind of wholesale lying about assets, and other eye-popping cases that are surfacing in the news media here, points to the staggering breadth of tax dodging that has long been a way of life here.
Such evasion has played a significant role in Greece’s debt crisis, and as the country struggles to get its financial house in order, it is going after tax cheats as never before. Various studies, including one by the Federation of Greek Industries last year, have estimated that the government may be losing as much as $30 billion a year to tax evasion — a figure that would have gone a long way to solving its debt problems. “We need to grow up,” said Ioannis Plakopoulos, who like all owners of newspaper stands will have to give receipts and start using a cash register under the new tax laws passed last month. “We need to learn not to cheat or to let others cheat.”
On the eve of an International Monetary Fund bailout deal that is sure to call for deep sacrifices here, including harsh austerity measures, layoffs and steep tax increases, many Greeks say they feel chastened by the financial crisis that has pushed the country to the edge of bankruptcy. But even so, changing things will not be easy. Experts point out that ducking taxes is part of a broader culture of bribery and corruption that is deeply entrenched. Mr. Plakopoulos, who supports most of the government’s new efforts, admits that he and his friends used to chuckle over the best ways to avoid taxes.
To get more attentive care in the country’s national health system, Greeks routinely pay doctors cash on the side, a practice known as “fakelaki,” Greek for little envelope. And bribing government officials to grease the wheels of bureaucracy is so standard that people know the rates. They say, for instance, that 300 euros, about $400, will get you an emission inspection sticker. Some of the most aggressive tax evaders, experts say, are the self-employed, a huge pool of people in this country of small businesses. It includes not just taxi drivers, restaurant owners and electricians, but engineers, architects, lawyers and doctors.
The cheating is often quite bold. When tax authorities recently surveyed the returns of 150 doctors with offices in the trendy Athens neighborhood of Kolonaki, where Prada and Chanel stores can be found, more than half had claimed an income of less than $40,000. Thirty-four of them claimed less than $13,300, a figure that exempted them from paying any taxes at all. Such incomes defy belief, said Ilias Plaskovitis, the general secretary of the Finance Ministry, who has been in charge of revamping the country’s tax laws. “You need more than that to pay your rent in that neighborhood,” he said.
He said there were only a few thousand citizens in this country of 11 million who last year declared an income of more than $132,000. Yet signs of wealth abound. “There are many people with a house, with a cottage in the country, with two cars and maybe a small boat who claim they are earning 12,000 euros a year,” Mr. Plaskovitis said, which is about $15,900. “You cannot heat this house or buy the gas for the car with that kind of income.”
The Greek government has set a goal for itself of collecting at least $1.6 billion more than last year — a modest goal, Mr. Plaskovitis believes. But European Union officials were so skeptical, Mr. Plaskovitis said, they would not even allow the figure to be included in the budget forecast used in negotiations over the bailout package. “They said, ‘Yes, yes, we have heard that before, but it never happens,’ ” he said.
Over the past decade, Greece actually lost ground in collecting taxes, even as the economy was booming. A 2008 European Union report on Greece tax shortfalls found that between 2000 and 2007, the country’s average growth in nominal gross domestic product was 8.25 percent. Its taxes grew at just 7 percent. How Greece ended up with this state of affairs is a matter of debate here. Some attribute it to Greece’s long history under Turkish occupation, when Greeks got used to seeing the government as an enemy. Others point out that, classical history aside, Greece is actually a relatively young democracy.
Whatever the reason, Kostas Bakouris, the president of the Greek arm of the anticorruption organization Transparency International, said that Greeks were constantly facing the lure of petty corruption. “If they go to the mechanic, it is one price without a receipt and quite a bit more with it,” Mr. Bakouris said. He said his own sister had recently told him that she was uncomfortable asking her doctor for a receipt. “I said that’s crazy,” he said. “But still, that feeling is out there.”
Various studies have concluded that Greece’s shadow economy represented 20 to 30 percent of its gross domestic product. Friedrich Schneider, the chairman of the economics department at Johannes Kepler University of Linz, studies Europe’s shadow economies; he said that Greece’s was at 25 percent last year and estimated that it would rise to 25.2 percent in 2010. For comparison, the United States’ was put at 7.8 percent.
The Finance Ministry believes that the new tax laws, which also increased the weight on income and value-added taxes, have laid the legal groundwork for better enforcement. In the past, the tax code gave many categories of workers special status. Entire professions were allowed to file a set income. For instance, newsstand owners could simply claim that they earned an income of 12,000 euros (about $15,900) and no questions were asked. Now, most of these exceptions have been eliminated and the tax code has been simplified. It also offers various incentives to make people collect receipts — an important step, officials say, in shrinking the off-the-books economy.
In addition, the tax department is being reorganized so that regional offices will have far less autonomy. Mr. Plaskovitis said that tax collectors had already begun using technology to crosscheck claims and that they had taken steps like asking luxury car dealerships for list of their clients. A lot of Greeks, he said, listed luxury cars as company cars, a practice that would be challenged in the future. “We do not believe you need a Porsche to sell Coca-Cola,” he said. Soon, Mr. Plaskovitis said, people will see results. “In the coming weeks,” he said, “we are going to be closing down companies, restaurants and doctors’ offices because they have not paid taxes.”
But how fast progress will come is an open question. The changes have provoked protests and deep resentment in some circles. For instance, the president of the union for doctors who work in state hospitals, Stathis Tsoukalos, 60, calls the loss of a special tax status for his doctors wrongheaded and unfair. He contended that the special low tax rate was given to make up for the fact that doctors received very low pay. Speaking of the doctors in the Kolonaki neighborhood who claimed small incomes, he said, they may have just opened their practices or bought real estate there with help from their parents.
Whether the country’s tax collectors are up to the task is also unclear. Many Greeks say tax collectors have a reputation for being among the easiest officials to bribe. Some say tax troubles are usually solved in a three way split: You pay a third of what you owe to the government, a third to the collector and a third remains in your pocket. Froso Stavraki, who has been a tax collector for 27 years and is now a high-ranking official in the union, readily concedes that there is some corruption in the ranks. But she contends that the politicians never wanted toughness. “The orders from above were to do everyday tax processing,” she said. “We were busy going over forms, checking on those who pay taxes, not those who didn’t.”
Will Greek Contagion Bring Portugal Down?
by Stefan Schultz
Will the Greek malaise spread to Portugal? Fears of a national bankruptcy are now also growing in Lisbon, even though the country is capable of getting its debt under control by itself. The problem is that markets no longer have faith in the Portuguese to fix their own affairs. "Fear defeats more people than any other one thing in the world," wrote the American philosopher Ralph Waldo Emerson. The current crisis in Greece shows that the fear of failure can also bring countries to their knees.
Greece's precarious financial situation has brought the state to the brink of bankruptcy in record time. Portugal could be next. The country is under pressure due to fears that it could be sucked into the Greek maelstrom. In the past few days, the government in Lisbon has experienced the power of international markets. On Wednesday, the rating agency Standard & Poor's announced it would downgrade Portugal's credit rating to A- and warned that further downgrades were possible.
The devaluation was partly based on technical reasons. As a result of the Greek crisis, nervousness spread on the bond markets. This increased the interest premiums on Portuguese government bonds. Standard & Poor's reacted by giving the country a lower rating. But this only accelerates the downward spiral: Investors become even more nervous, the interest rates on Portugal's bonds rise rapidly and new downgrades become more likely. This panic mechanism has been influencing the bond markets for months, significantly exacerbating the debt problem in countries such as Portugal. In the case of Portugal, however, the fears are hardly justified. Economically and financially, the country is far better off than Greece:
- Although Portugal's budget deficit skyrocketed up to 9.4 percent of gross domestic product during the global economic crisis, its national debt, at 77 percent of annual economic output, is only slightly higher than Germany's. Greece's debt, in contrast, is about 125 percent of GDP.
- The government in Lisbon will not need very much fresh money in the foreseeable future. In May, they need to refinance around €7 billion ($9.3 billion), with a total of about €21 billion for the whole of 2010. Under normal circumstances, those sums could be raised in the markets.
- Even Standard & Poor's had a different opinion about Portugal just a few weeks ago. As recently as March 29, the rating agency decided that it did not need to downgrade Portugal's credit rating. That raises the question of what is supposed to have changed about Portugal's economic situation since then, apart from the fact that interest rates on government bonds have increased as a result of unrest in the market.
Indeed, the crisis that Portugal is facing is mainly a political one. "Early elections and postponed reforms have seriously shaken confidence in the government's ability to act," says Pedro Tadeu of the newspaper Diário de Notícias. In addition, Prime Minister José Socrates of the Socialist Party (PS) is head of a minority government, meaning that the opposition can block its reforms at any time. Currently, however, the government and the largest opposition party, the conservative PSD, are demonstrating unity and determination. On Wednesday, Socrates and opposition leader Pedro Passos Coelho stood side by side at an appearance in the Sao Bento Palace in Lisbon, the seat of the Portuguese parliament, and promised decisive action against the "unjustified speculative attacks."
To achieve that end, Socrates' "Program for Stabilization and Growth" (PEC) will be changed. Austerity measures that were originally planned for the coming years will now be introduced in 2010. Tax increases are also planned. The tax rate on incomes of more than €150,000 will be increased to 45 percent, which will bring the state an extra €1.3 billion by 2012, according to the business newspaper Jornal de Negocios. In addition, the government plans to introduce a stock market tax and new highway tolls, and cut back unemployment benefits, before the end of 2010.
The chances of Socrates' savings package being implemented are good. Opposition leader Passos Coelho, who has only been in office for a few weeks, said his party would support the legislation in parliament. He is generally regarded as more cooperative than his predecessor, Manuela Ferreira Leite, who for a long time refused to cooperate with Socrates' savings plans. In February, she even supported a regional finance bill, against the will of the government, that allows the autonomous regions of Madeira and the Azores to accumulate up to €400 million in new debt over the next four years.
On March 25, however, the PSD finally approved Socrates' austerity package. After the rating agency Fitch downgraded Portugal's credit rating, the PSD supported the goals of the program indirectly by abstaining in a parliamentary vote. Socrates and Passos Coelho want to avoid such wrangling this time around. The government's new savings efforts are expected to be approved by parliament in the next few days. The legislation is considered certain to pass, given that the PS and PSD between them have an almost two-thirds majority in the Portuguese parliament.
Socrates is getting less support from the unions, however, as the government wants to freeze civil servants' salaries. There are plans to reduce personnel costs by 10 percent by 2013, which would save the state about €100 million a year. Taxes will also be increased. The only workers who will be exempt are those who earn no more than €518 a month, according to the television station RTP. According to the mass-circulation daily Correio da Manha, Socrates' austerity program "will crush the middle class." Trade unions have therefore let the prime minister feel their power. On Tuesday, Portuguese railway workers went on strike, as did ferry and bus workers.
The industrial action led to numerous traffic jams in Lisbon's metropolitan area as commuters were forced to travel to work by car. "The protests will grow," threatened Manuel Carvalho da Silva, the head of the largest union in the country, the CGTP. Observers do not expect many political consequences, however. "Angry riots like those in Greece are rather unusual in Portugal," says Eva Gaspar, editor-in-chief of the Jornal de Negocios. So the political situation is comparably stable. But the question remains: Is Socrates' savings plan realistic? Will he be able to save enough money quickly with his plan? Ultimately, Portugal wants to cuts its record deficit of 9.4 percent of gross domestic product to 2.8 percent by 2013. To do so, the country will need to find savings of €13.5 billion.
"It's ambitious," said Francesco Franco, an economics professor at the New University of Lisbon. "But not impossible." Socrates actually has one decisive advantage, Franco says: He can sell off valuable state holdings to raise money. It would admittedly be a one-time effect, but it would guarantee that the country could quickly eliminate debts. The government has said it wants to sell its holdings in 17 firms, including its shares in the energy firm Galp and Portuguese national airline TAP. The sale of these shares is expected to raise a total of €1.2 billion by the end of 2010. Socrates wants to save further money by delaying previously planned major infrastructure projects. The planned high-speed railway line between Spain and Portugal, for example, is to be delayed by two years. It is also hoped that the economic upswing will increase tax revenues and decrease unemployment and bring further money into the government's coffers.
So the government has good chances of regaining control of its debt problems. But one still can't say that the country has been economically reformed. Ever since it joined the euro zone in 1999, Portugal, like Spain and Greece, has had a growing structural problem. "Triggered by the commitment by Portugal to join the euro, a sharp drop in interest rates and expectations of faster growth both led to a decrease in private saving and an increase in investment," MIT economist Oliver Blanchard wrote in his classic analysis, "The Difficult Case of Portugal." For years, this meant that wages grew faster than the economy and consumption also increased. But the growth was deceptive: It was largely driven by an increase in imports. At the same time, Portuguese productivity sank.
"Portugal lived beyond its means for decades," says Ricardo Reis, an economics professor at New York's Columbia University. "The crisis has caused this imbalance to become unbearable." He says that as the country embarks on its austerity course, it must also quickly increase its productivity. The Portuguese constitution prohibits making cuts to public sector wages, so other solutions need to be found. The bloated public sector needs to be shrunk, competition needs to be boosted and it needs to be made easier for people to set up companies. "Otherwise consumption will collapse in three to five years and the quality of life will decline," says Reis.
Credit Rating Agencies Playing Big Roll In European Debt Crisis
by Stevenson Jacobs and Daniel Wagner
The downgrading of European debt is turning up the heat on the firms that issue the ratings. Some European officials are calling for curbs on rating agencies like Standard & Poor's, Moody's Corp. and Fitch Ratings. They argue that conflicts of interest and bad information make the agencies' assessments unreliable, even dangerous. Germany's foreign minister went so far Thursday as to suggest that the European Union should create its own rating agency. He spoke after downgrades of Greece and Portugal roiled financial markets and stoked fears that Europe's debt crisis was spreading.
How ratings agencies are paid is also coming under scrutiny. The money they earn comes from the institutions whose products and debt they rate – a point of contention in the U.S. and Europe. At a hearing last week on the agencies' role in the financial crisis, U.S. Sen. Carl Levin called that pay system an "inherent conflict of interest." Legislation in Congress to overhaul the financial regulatory system could change how the rating agencies do business. Critics note that the agencies gave safe ratings to high-risk U.S. mortgage investments that later imploded, triggering the financial crisis and a deep recession.
Despite the poor publicity, the agencies are still generating big money. S&P, owned by the McGraw-Hill Cos., earned $451.5 million in revenue in the first quarter, up 15 percent from a year ago. Moody's first-quarter profit jumped 26 percent to $113.4 million as more companies issued debt during the quarter, particularly junk bonds. Warren Buffett's Berkshire Hathaway Inc. remains the largest shareholder of Moody's. But since March 2009, it's reduced its stake from 48 million shares to 30.8 million shares. The profits and outsize influence of the rating firms have rankled European governments.
German Foreign Minister Guido Westerwelle on Thursday told WAZ newspaper group that the EU "should counter the work of rating agencies with efforts of its own." He cited the potential conflict of interest of having the rating firms develop, sell, and rate financial products all at the same time. Westerwelle's comments came two days after S&P cut Greece's sovereign debt to 'junk' status and dropped Portugal's down two notches. Those downgrades sent financial markets from London to Hong Kong plunging. Investors feared that more European countries would be dragged into the region's debt debacle.
A senior German economist criticized the downgrades. "We should not make the welfare of Europe dependent on rating agencies," Peter Bofinger of the German government's independent economic advisory panel told "Welt" newspaper. He noted the agencies' failure to spot problems before the financial crisis. Yet less than two years after the crisis peaked, rating agencies still carry weight. A big reason is that many institutional investors – from central banks to pension funds – require safe ratings on the debt of countries, firms or securities they invest in. A downgrade from S&P or Moody's might not tell investors anything they don't already know. But it can force a central bank or investment fund to shed the downgraded investment. That's why it can roil financial markets.
If Moody's follows S&P and downgrades Greece to junk, the European Central Bank, under its rules, could no longer accept Greek bonds as collateral in lending to Greece. It would become harder for Greece to roll over its debt into new loans. Fears of a spreading debt crisis would grow. That doesn't mean Wall Street bows to the assessments of rating agencies. "I totally ignore the ratings agencies – to a point," said Andy Brenner, head of emerging markets at Guggenheim Securities. He said ratings agencies tend to act too late. Greece's debt, Brenner noted, has been trading at junk levels for weeks.
Brenner pointed out that Brazil, Mexico and Russia have credit ratings similar or worse than Greece's. Yet 10-year notes for Brazil, Mexico and Russia yield around 5 percent. By contrast, Greece's 10-year notes offer around 10 percent. That means investors view them as twice as risky. Some analysts say the rating agencies have a better track record at rating countries' debt than they do complex debt investments like mortgage securities. "It's much easier to understand their metrics when it comes to downgrading countries," says Andrew B. Busch, a currency strategist at BMO Capital Markets in Chicago. Those metrics include how much tax revenue the country is using to pay down its debt and how fast its economy is growing.
EU officials remain unconvinced. And some are openly deriding the rating agencies. "Who is Standard & Poor's anyway?" EU spokesman Amadeu Altafaj Tardio said Wednesday. He said the agency should better assess "realities on the ground," such as financial rescue talks in Athens "that are making rapid and solid progress." A top International Monetary Fund official also questioned the agencies' accuracy. He argued that their assessments reflect mainly investors' perceptions of a nation's financial health. "That's why you shouldn't believe too much in what they say," IMF managing director Dominique Strauss-Kahn said Wednesday.
S&P said it's confident in how it rates countries' creditworthiness. "Our sovereign ratings generally have performed as expected, and we continue to call them as we see them when credit quality changes," spokesman Chris Atkins said. He said S&P improved the quality and transparency of its ratings after the U.S. mortgage meltdown. Analysts now receive more training and are rotated regularly among countries so as not to become beholden to one country's interests.
All three rating agencies are facing new rules that could change how they operate in the U.S. Under an overhaul of financial regulation being debated by Congress, investors could sue rating agencies for assigning recklessly high ratings. In the past, courts have held that credit ratings are constitutionally protected free speech. The agencies also would be forced to register with the Securities and Exchange Commission. It addition, they would have to disclose more information about how they determine their ratings and how accurate they've proved over time. The SEC could revoke the registrations of rating agencies that consistently assign inaccurate ratings.
To address the conflict-of-interest issue, a bill passed by the House would require agencies to disclose their relationships with banks. The EU has drafted a code of conduct for rating agencies that takes effect in December. It aims to reduce conflicts of interest and force rating agencies to disclose their methodology.
Europe’s Debt Woes Start to Complicate China’s Money Moves
by Keith Bradsher
Spreading problems in Europe’s sovereign debt markets pose potential challenges for China, which has been stepping up its investments in European government bonds and relies on Europe as its biggest export market. The turmoil that Europe’s difficulty has caused in financial markets already appears to have caused tens of billions of dollars in paper losses in China’s foreign exchange reserves. And the problems may complicate the timing of an expected Chinese move to break the informal peg of the Chinese renminbi to the dollar, Chinese and Western economists and bankers said on Thursday.
Yet, officials in Beijing have almost completely avoided public comments and are showing little enthusiasm for playing a direct role in the complex diplomatic and financial negotiations as Greece, Portugal and Spain struggle to respond to downgrades in their sovereign debt ratings. China’s role, if any, would probably come via its participation as a big contributor to the International Monetary Fund, economists and bankers say.
Jiang Yu, a Chinese foreign ministry spokeswoman, gave the first official Chinese response during a routine press briefing in Beijing on Thursday afternoon, and it implied China’s preference for watching from the sidelines. “We hope the issue can be resolved satisfactorily and that the affected countries would soon emerge from their difficulties and achieve economic recovery,” she said.
With $2.4 trillion in foreign exchange reserves, China has considerably more cash for any financial rescue than even the I.M.F. But the central bank, the People’s Bank of China, which oversees the foreign reserves, has been extremely wary of deploying that money directly as highly visible investments in troubled economies. It mainly refrained from doing so even during the depths of the global financial crisis in late 2008 and early 2009.
The Chinese government has preferred to work through the I.M.F., which China has tended to regard as a better credit risk and less politically sensitive than many individual countries. China’s share of cash committed to I.M.F. shares, known as its quota, has nearly doubled since the Asian financial crisis in 1997 and 1998, to $12.2 billion. The I.M.F. board has approved another increase soon, which would raise China’s stake in the multilateral organization to 4 percent from 3.72 percent.
China is already the fourth-largest holder of quota rights at the I.M.F., after the member countries of the European Union, with 32.4 percent; the United States, with 17.1 percent; and an Asian bloc informally led by Japan, with 11.5 percent. China agreed last September to buy up to $50 billion worth of bonds issued by the I.M.F. to help the multilateral agency strengthen its lending capacity, in the first such deal done by the I.M.F. In recognition of China’s rising influence, Zhu Min, a deputy governor of the People’s Bank of China, was named on Feb. 24 to become the special adviser to the I.M.F.’s managing director, Dominique Strauss-Kahn, and will start work on May 3.
But China has been wary of using its influence publicly, in keeping with its overriding foreign policy principle of seeking a “peaceful rise” in China’s role in the world. “China is unlikely to take a leading role in defining the terms of the I.M.F.’s assistance program to Greece,” said Eswar Prasad, a former head of the China desk at the I.M.F. “It is in China’s interest to see the situation in Europe stabilized, as it is their most important export market. And they are likely to get behind whatever amount of assistance and types of conditions the I.M.F. thinks are most likely to achieve that objective.”
China closely guards any details on the currency allocation of its reserves. Western bankers estimate that the Chinese reserves are about 70 percent invested in dollar-denominated assets, mainly Treasury notes and bonds, and 20 to 25 percent invested in euro-denominated assets, with the rest in British pounds, Japanese yen and other currencies. Chinese officials have been looking for safe ways to invest the country’s vast savings overseas, and euro-denominated government bonds had appeared until very recently as an attractive alternative to Treasuries, said Yu Yongding, a former member of the monetary policy committee of the People’s Bank of China.
“China needs deep, liquid, safe financial markets,” said Mr. Yu, who is the director of world economics and politics at the Chinese Academy of Social Sciences, an advisory body to China’s cabinet. Premier Wen Jiabao has even voiced public concern in the last year about rising American budget deficits and the ability of the United States to protect the buying power of Chinese money invested in Treasuries.
The People’s Bank of China has financed its country’s huge foreign reserves by borrowing money domestically, mainly from the state-owned banking system; the prospect of losses on those reserves has been a sensitive subject that is frequently censored when it pops up in Chinese Internet discussion forums. But any losses on European investments are likely to be modest, relative to China’s overall reserves, barring an actual ripple of defaults across Europe.
The euro has lost a tenth of its value against the dollar in recent weeks. But a tenth of the 20 to 25 percent of the portfolio invested in euros still works out to a loss of only 2 to 2.5 percent on the entire portfolio. Because the Chinese currency, the renminbi, is informally pegged at about 6.83 to the dollar, the euro’s slump against the dollar has meant a slump against the renminbi as well. This is making Chinese goods more expensive in Europe.
“The slump in the euro has really affected our business, since Europe accounts for 80 percent of our business and we receive euros from our clients,” said Wu Xiaozhan, the sales manager of Yiwu Disa Jewelry and Belt Company, a producer of beads and other costume jewelry components in Yiwu City, in east-central China. “These are all long-standing clients, so for the time being we have not considered raising prices or switching to invoicing in another currency. We will just bear the loss for now.”
Chinese leaders have been preparing to break the renminbi’s link to the dollar, because preserving that link has limited their ability to control speculative bubbles in the Chinese economy. It has also caused them to accumulate enormous foreign exchange reserves through currency market intervention.
Australia Plans to Impose 40% Tax on Resource Profits
by Gemma Daley and Marion Rae
Australia will impose a 40 percent tax on the profits of resource companies like BHP Billiton Ltd. and Rio Tinto Group to pay for infrastructure, retirement and company levy changes as part of the broadest overhaul of its tax system since the Second World War. The government, responding to Treasury Secretary Ken Henry’s 10-year tax plan, said the resource tax would start in 2012 and raise A$12 billion ($11.1 billion) in its first two years.
The move is a pre-election push to better tap into the nation’s mining boom fueled by commodities demand from China and India and comes as Prime Minister Kevin Rudd prepares for an election later this year. “This will use super profits on resources owned by all Australians,” Rudd told reporters in Canberra, saying he’s prepared for a backlash to the measures. “This will help convert Australia’s strong economic position today into enduring prosperity.”
The changes set up a potential clash between Rudd and resources companies that make up 9 percent of the economy and last week warned that a 40 percent levy and double taxation with state royalties would threaten $108 billion worth of planned investment. “If implemented, these proposals seriously threaten Australia’s competitiveness, jeopardize future investments and will adversely impact the future wealth and standard of living of all Australians,” BHP’s Chief Executive Officer Marius Kloppers said in an e-mailed statement today. The company’s effective tax rate will increase to 57 percent from 2013 from 43 percent now, it said.
BHP, the world’s biggest mining company with 51 percent of its assets in Australia, will have earnings cut by 19 percent as a result of the tax, Merrill Lynch & Co. said in an April 27 report on the 40 percent tax. Rio, the world’s second-largest iron ore exporter, which has about a third of its assets in Australia, would see a 30 percent earnings cut. The government today said it will compensate companies for the state royalties they have paid. “Under the plan announced today, Australia will have the highest taxed mining industry in the world,” Minerals Council of Australia Chief Executive Officer Mitch Hooke said in an e- mailed statement. “Australia’s hard-earned reputation as a stable investment environment will be dramatically undermined.”
The government runs the risk of “taking away from Australia the strongest industry we have and the one that saved us from the global financial crisis,” said Keith De Lacy, chairman of Brisbane-based Macarthur Coal Ltd., the world’s largest producer of pulverized coal. “Always 50 percent of our net profits went into development and exploration and so much of that is going now so obviously we’ll grow slower.”
The introduction of the resource tax would cut Australia’s competitiveness, Citigroup Inc. said on April 28 before the release of the review. Mining companies’ tax burden currently stands at 35 percent, Citigroup said in its report last week. Chinese and Indian demand for resources from Australia, the world’s biggest exporter of coal, iron ore and alumina, helped the A$1.2 trillion economy skirt recession during the global financial crisis. China is the nation’s largest resource customer.
Rudd’s Labor government, which has led the opposition Liberal-National coalition in opinion polls, commissioned the tax review two years ago to create a simpler and fairer system to meet the needs of a growing and ageing population. One quarter of a projected population of 36 million will be aged 65 and over by 2050, increasing pressure on roads, rail, ports, schools and hospitals. The government will use the resource tax revenue to create a A$5.6 billion infrastructure fund, cut company taxes to 28 percent in mid-2014 from the current 30 percent and boost retirement funds, now worth A$1.3 trillion. It will also give a tax concession for resource exploration, including geothermal, affecting 4,300 companies, Treasurer Wayne Swan said.
The company tax rate, reduced to 30 percent from 36 percent by the previous Liberal-National government, will be cut to 28 percent by mid-2014, with 720,000 small businesses getting a one-year head-start. The government may decrease the rate further. The government will also increase the amount companies have to pay into people’s retirement fund to 12 percent from 9 percent of their gross salary in mid-2019. Australia will also make it more attractive for some 8.4 million Australian workers to increase their own contributions to the pool and the changes will add A$85 billion to the A$1.34 trillion fund, Swan said.
In total, the government’s tax policy changes will add 0.7 percent a year to the nation’s economy. Economic growth in Australia will accelerate to 3.5 percent in 2011 from 3 percent this year, and the country will continue to be among nations leading the world on raising borrowing costs, the International Monetary Fund said on April 21. Glenn Stevens, the first Group of 20 central bank governor to raise rates after the global recession, also expects Australia’s economic growth to strengthen this year.
Gulf Stream May Send Oil Spill Up East Coast
by Allen G. Breed and Seth Borenstein
"It will be on the East Coast of Florida in almost no time," Graber said. "I don't think we can prevent that. It's more of a question of when rather than if."
A sense of doom settled over the American coastline from Louisiana to Florida on Saturday as a massive oil slick spewing from a ruptured well kept growing, and experts warned that an uncontrolled gusher could create a nightmare scenario if the Gulf Stream carries it toward the Atlantic. President Barack Obama planned to visit the region Sunday to assess the situation amid growing criticism that the government and oil company BP PLC should have done more to stave off the disaster. Meanwhile, efforts to stem the flow and remove oil from the surface by skimming it, burning it or spiking it with chemicals to disperse it continued with little success.
"These people, we've been beaten down, disaster after disaster," said Matt O'Brien of Venice, whose fledgling wholesale shrimp dock business is under threat from the spill. "They've all got a long stare in their eye," he said. "They come asking me what I think's going to happen. I ain't got no answers for them. I ain't got no answers for my investors. I ain't got no answers." He wasn't alone. As the spill surged toward disastrous proportions, critical questions lingered: Who created the conditions that caused the gusher? Did BP and the government react robustly enough in its early days? And, most important, how can it be stopped before the damage gets worse?
The Coast Guard conceded Saturday that it's nearly impossible to know how much oil has gushed since the April 20 rig explosion, after saying earlier it was at least 1.6 million gallons – equivalent to about 2 1/2 Olympic-sized swimming pools. The blast killed 11 workers and threatened beaches, fragile marshes and marine mammals, along with fishing grounds that are among the world's most productive. Even at that rate, the spill should eclipse the 1989 Exxon Valdez incident as the worst U.S. oil disaster in history in a matter of weeks. But a growing number of experts warned that the situation may already be much worse.
The oil slick over the water's surface appeared to triple in size over the past two days, which could indicate an increase in the rate that oil is spewing from the well, according to one analysis of images collected from satellites and reviewed by the University of Miami. While it's hard to judge the volume of oil by satellite because of depth, it does show an indication of change in growth, experts said. "The spill and the spreading is getting so much faster and expanding much quicker than they estimated," said Hans Graber, executive director of the university's Center for Southeastern Tropical Advanced Remote Sensing. "Clearly, in the last couple of days, there was a big change in the size."
Doug Suttles, BP's chief operating officer for exploration and production, said it was impossible to know just how much oil was gushing from the well, but said the company and federal officials were preparing for the worst-case scenario. In an exploration plan and environmental impact analysis filed with the federal government in February 2009, BP said it had the capability to handle a "worst-case scenario" at the Deepwater Horizon site, which the document described as a leak of 162,000 barrels per day from an uncontrolled blowout – 6.8 million gallons each day.
Oil industry experts and officials are reluctant to describe what, exactly, a worst-case scenario would look like – but if the oil gets into the Gulf Stream and carries it to the beaches of Florida, it stands to be an environmental and economic disaster of epic proportions. The Deepwater Horizon well is at the end of one branch of the Gulf Stream, the famed warm-water current that flows from the Gulf of Mexico to the North Atlantic. Several experts said that if the oil enters the stream, it would flow around the southern tip of Florida and up the eastern seaboard. "It will be on the East Coast of Florida in almost no time," Graber said. "I don't think we can prevent that. It's more of a question of when rather than if."
At the joint command center run by the government and BP near New Orleans, a Coast Guard spokesman maintained Saturday that the leakage remained around 5,000 barrels, or 200,000 gallons, per day. But Coast Guard Adm. Thad Allen, appointed Saturday by Obama to lead the government's oil spill response, said no one could pinpoint how much oil is leaking from the ruptured well because it is about a mile underwater. "And, in fact, any exact estimation of what's flowing out of those pipes down there is probably impossible at this time due to the depth of the water and our ability to try and assess that from remotely operated vehicles and video," Allen said during a conference call.
The Coast Guard's Allen said Saturday that a test of new technology used to reduce the amount of oil rising to the surface seemed to be successful. During the test Friday, an underwater robot shot a chemical meant to break down the oil at the site of the leak rather than spraying it on the surface from boats or planes, where the compound can miss the oil slick. From land, the scope of the crisis was difficult to see. As of Saturday afternoon, only a light sheen of oil had washed ashore in some places. The real threat lurked offshore in a swelling, churning slick of dense, rust-colored oil the size of Puerto Rico. From the endless salt marshes of Louisiana to the white-sand beaches of Florida, there is uncertainty and frustration over how the crisis got to this point and what will unfold in the coming days, weeks and months.
The concerns are both environmental and economic. The fishing industry is worried that marine life will die – and that no one will want to buy products from contaminated water anyway. Tourism officials are worried that vacationers won't want to visit oil-tainted beaches. And environmentalists are worried about how the oil will affect the countless birds, coral and mammals in and near the Gulf. "We know they are out there" said Meghan Calhoun, a spokeswoman from the Audubon Aquarium of the Americas in New Orleans. "Unfortunately the weather has been too bad for the Coast Guard and NOAA to get out there and look for animals for us."
Fishermen and boaters want to help contain the oil. But on Saturday, they were again hampered by high winds and rough waves that splashed over the miles of orange and yellow inflatable booms strung along the coast, rendering them largely ineffective. Some coastal Louisiana residents complained that BP, which owns the rig, was hampering mitigation efforts. "I don't know what they are waiting on," said 57-year-old Raymond Schmitt, in Venice preparing his boat to take a French television crew on a tour. He didn't think conditions were dangerous. "No, I'm not happy with the protection, but I'm sure the oil company is saving money."
As bad as the oil spill looks on the surface, it may be only half the problem, said University of California Berkeley engineering professor Robert Bea, who serves on a National Academy of Engineering panel on oil pipeline safety. "There's an equal amount that could be subsurface too," said Bea. And that oil below the surface "is damn near impossible to track." Louisiana State University professor Ed Overton, who heads a federal chemical hazard assessment team for oil spills, worries about a total collapse of the pipe inserted into the well. If that happens, there would be no warning and the resulting gusher could be even more devastating because regulating flow would then be impossible. "When these things go, they go KABOOM," he said. "If this thing does collapse, we've got a big, big blow."
BP has not said how much oil is beneath the Gulf seabed Deepwater Horizon was tapping, but a company official speaking on condition of anonymity because he was not authorized to discuss the volume of reserves, confirmed reports that it was tens of millions of barrels – a frightening prospect to many. Louisiana Gov. Bobby Jindal said that he has asked both BP and the Coast Guard for detailed plans on how to protect the coast. "We still haven't gotten those plans," said Jindal. "We're going to fully demand that BP pay for the cleanup activities. We're confident that at the end of the day BP will cover those costs." In a statement late Saturday, a Coast Guard spokesman said the governor's office helped develop the plans that Jindal referred to.
Capt. Ron LaBrec said federal and company officials had been working closely with the governor's office "since day one" to implement contingency "which were developed in coordination with state and local leadership before this incident began." Obama has halted any new offshore drilling projects unless rigs have new safeguards to prevent another disaster. As if to cut off mounting criticism, on Saturday White House spokesman Robert Gibbs posted a blog entitled "The Response to the Oil Spill," laying out the administration's day-by-day response since the explosion, using words like "immediately" and "quickly," and emphasizing that Obama "early on" directed responding agencies to devote every resource to the incident and determining its cause.
In Pass Christian, Miss., 61-year-old Jimmy Rowell, a third-generation shrimp and oyster fisherman, worked on his boat at the harbor and stared out at the choppy waters. "It's over for us. If this oil comes ashore, it's just over for us," Rowell said angrily, rubbing his forehead. "Nobody wants no oily shrimp."