"Breaker boys, Woodward coal mines, Kingston, Pennsylvania"
For more on the breaker boys, please see the bottom of this post
Ilargi: In order to make it easier for our readers to navigate the main points we try to make at The Automatic Earth, here's Stoneleigh's updated version of the Primer Guide:
Stoneleigh: As The Automatic Earth has grown and continued to catalogue the on-going financial crisis, it has been getting increasingly difficult for readers to find our view of the big picture in one place. Since it has been exactly one year since we issued our first primer guide, and several new primers have been added in the meantime, it seems an opportune moment to offer an updated distillation of our worldview.
The Resurgence of Risk, which appeared at The Oil Drum Canada in August 2007 provides the background to how we came to be in our present predicament. It is by far the longest of the primers, and its purpose is to explain in some depth the nature of our credit bubble, the role of 'financial innovation', the distinction between currency inflation and credit hyper-expansion and the mechanism by which value disappears as a bubble deflates.
For further explanation of the ponzi nature of bubbles, the spectrum of ponzi dynamics underlying many economic phenomena and the implications of this for where we are headed, see From the Top of the Great Pyramid.
This ties in with an earlier piece from The Oil Drum Canada, Entropy and Empire , detailing the progression of hegemonic power from empire to empire, as each rises, over-reaches, falls and passes the mantle on to its successor.
The political picture is further developed in Economics and the Nature of Political Crisis and Corruption, Culpability and Short-Termism, with a more specific look at Europe in The Imperial Eurozone (With all That Implies).
When bubbles reach their maximum extent, they invariably deflate. Our explanation as to why this is inevitable can be found in Inflation Deflated, followed by, The Unbearable Mightiness of Deflation, a rebuttal to inflationist Gary North. An Interview with Stoneleigh provides a more recent and more comprehensive piece on deflation and its consequences.
We dispute classical economic theory and the received wisdom as to the nature of markets. Markets are not objective, mechanical and rational as the Efficient Market Hypothesis would have you believe. Our explanation of markets as human phenomena grounded in destabilizing positive feedback can be found in Markets and the Lemming Factor (with kudos to Robert Prechter, who has been developing the hugely important theory of socionomics for many years).
We have a number of articles on specific aspects of our current crisis. Our view of real estate can be found in Welcome to the Gingerbread Hotel. Employment is covered in War in the Labour Markets.
The Special Relativity of Currencies and Dollar-Denominated Debt Deflation address our view of currency inter-relationships and the value of currency relative to available goods and services.
Our view of the intersection between peak oil and finance can be found in Energy, Finance and Hegemonic Power and Oil, Credit and the Velocity of Money Revisited, and our view of the future of power systems is explained in Renewable Power? Not in Your Lifetime and A Green Energy Revolution?.
Our take on the future for gold can be found in A Golden Double-Edged Sword, and our view of -global- trade is covered in The Rise and Fall of Trade.
Our predictions for the future in a nutshell are available in point form in 40 Ways to Lose Your Future .
Our prescription for facing the future is presented in How to Build a Lifeboat .
This is our attempt to convey what we as individuals can hope to do about it for ourselves, our families and friends. We cannot avoid living through a Greater Depression, but we can take action, and, being forewarned, we can hopefully avoid many pitfalls. We can attempt to avoid becoming part of the herd that is determined to throw itself off a cliff.
Finally, our most theoretical piece, Fractal Adaptive Cycles in Natural and Human Systems, connects ecological and socioeconomic cycles through an analogous framework, drawing together the work of CS Holling, Robert Prechter and Joseph Tainter. The big picture is of crucial importance as we have reached, and passed, the pinnacle of a golden age. We are moving into an era of uncertainty and upheaval such as none of us have hitherto experienced but all of us must try to navigate successfully.
We at The Automatic Earth will continue to provide what assistance we can with that process. The TAE world tour continues, with a view to turning virtual communities into real ones. By popular demand, we will shortly be making available a recording of one of these presentations. Watch this space.
Regime Change for the Stock Market
by Numerian - The Agonist
The financial press likes to talk up those occasions when the Dow presses on above 10,000. Such talk lately has become desultory, since it seems every other week the Dow lurches below 10,000 and then manages to climb its way back up. The market has been in this funk since February of this year, when the Dow began its most recent push from below 10,000, all the way to a peak around 11,200, only to fall three times below the 10,000 level since and recover with less and less conviction.
Is the market creating a topping pattern, or is this merely a consolidation period to be followed by new highs for the year? This is the perennial question whenever the market trades sideways, allowing the bulls and bears to thrash out the economic arguments, and ultimately allowing real world conditions to resolve whether the market will break out on the upside or downside.
Investors don’t often appreciate that this situation has persisted for over a decade. The Dow first breached the 10,000 level in the 1990s, on its way to over 14,000 at the peak, but down last year to 6,600 at the low. In other words, the market has traded in a broad range for a very long period of time, and the same questions we are asking about the short term market apply. Is the stock market biding time until it takes off again, or is this some massive topping pattern which will eventually drag the market much lower than 6,600?
The optimists like to say that the history of the stock market in the US is on their side. Time and again during the past 100 years bear markets come to an end and new highs follow. There is actually a real argument at work here: given that the Federal Reserve debases the currency by allowing some amount of inflation every year, and given that the price level of most goods and services rises over time because of this, it is only natural that stock prices should rise with the rate of inflation as well.
The pessimists say that this time is different. The Fed is facing deflation, not inflation, and stocks are especially vulnerable in deflationary times. But if this is true – and certainly there is considerable evidence of deflation in the global economy – why are stock prices even as high as 10,000? What has been holding the stock market up?
The answer to this problem lies with the fact that the stock market is ultimately about pricing the equity of thousands of different companies, and that means that investors make estimates about all the potential profits down the road of a particular company, and price the potential growth or decline in a stock accordingly. What this means is that investors hold their breath at the start of every quarter when companies announce their earnings for the previous quarter – the very thing the market is undergoing right now.
And since earnings have been very good for a very long time for the typical company, the stock market has been able to levitate itself despite the tech bubble collapse, the housing market catastrophe, the credit crisis, and the recent flash crash. Corporate earnings trump everything in the stock market, and unless there is some sea change in the prospect for corporate earnings, the stock market can push upwards even in the face of a persistent economic recession, or even a depression, which is what many consumers are experiencing. What, then, is the sideways trading we have seen both short term and long term telling us about corporate earnings?
It is telling us that the real battle in the stock market is not with the bulls and the bears, but with the corporations and the consumer. Corporations since the Ronald Reagan presidency have taken a larger and larger slice of the economic growth in this country, to the point where the imbalance is seriously against the consumer. Wages and benefits have stagnated for over 20 years in the US, while corporate earnings have surged. An estimated 30 million people in the US are living below the poverty level, while the top 1% of the population, who are mostly corporate executives and their families, enjoy unprecedented wealth from their stock grants and options.
The sideways trading we are experiencing is expressing uncertainty as to whether the era of corporate dominance at the expense of the consumer is over. Corporations have held the trump cards for over 30 years, having shipped millions of jobs overseas, laid off tens of millions of Americans, held salaries and wages flat, cut benefits, eliminated overtime, increased the workload, and converted employees to contractor status to avoid paying any benefits at all. These initiatives, along with generous reductions in their tax bills, to the point where any number of large corporations pay no tax at all, have fed directly into corporate net income and executive compensation.
In order to maintain their lifestyle, consumers have taken on debt at levels that are beginning to cripple the middle class. The hope that home asset values would increase over time to pay back these debts has now proven a mirage given that home values in the US have fallen over 40% since 2007. With the housing collapse it is now evident that most consumers are heavily over-indebted and have no room for more debt, a sentiment the consumer shares with the banks that no longer see the consumer as a good credit risk.
This situation, ironically, gives the consumer the "leverage" to turn the tables against the corporations. Consumers have no choice but to cut back drastically on their spending, to default on their debt, or to do both. Both are now happening, though spending cuts far exceed defaults because banks are loath to accept the existential damage of writing off all the consumer loans that are already seriously delinquent. The result of this is that consumer spending has never really recovered in this depression, despite what retail sales numbers may say, because what growth in sales has occurred has been provided by initiatives like the Cash for Clunkers program, the $8,000 home buyers credit, or the freed up cash from homeowners in default on their mortgage who have not yet been forced out of their homes.
Wall Street analysts and financial media don’t want to believe that the era of cheap credit they have known all their lives is over. The banks and corporations can’t accept that a permanent shift has come to the US economy, which is operating on half of the credit that was available up to 2007 when the securitization process and the shadow banking system still functioned. Even the Fed does not want to accept that the support it has given to the mortgage securities market or to the commercial paper market represents a permanent role for the government. The Fed keeps trying to pass these duties back to the private sector, and persists in the illusion that the securitization market is going to pop back into life any day now.
These are further reasons why the Dow keeps holding its head above 10,000. Wall Street in particular wants desperately to believe that the good old days are going to return. It cannot see that a regime change has come to the markets, one in which corporations will be increasingly on the defensive, hounded by governments everywhere looking to raise tax revenue, and assaulted by a permanent buyers strike from consumers adjusting to their own drop in living standards.
As for the banking sector – which is enormously profitable compared to most any other industry – the long slow slide to mediocre profits as the norm has begun. Both banks and consumers are ripping up credit cards as fast as they can be paid off. Individual investors are fleeing the stock market and along the way pulling their money out of asset pools run by the banks. Trading is a lot more risky now that volatility has returned to the market. The equity extraction business called home equity lines of credit is shrinking quickly now that home equity is falling, not rising.
Other equity extraction businesses, like High Frequency Trading, are bound to be outlawed the next time another flash crash occurs. Corporate mergers and acquisitions are withering on the vine because cheap financing is gone and buyers have to pony up cash instead of debt to buy another company. All in all, there isn’t any main line of the banking business that isn’t under assault, and the big banks in particular may be toast if consumer defaults accelerate, especially strategic defaults where the consumer walks away from a mortgage even though they can continue paying it.
Another reason corporations don’t want to accept the regime change that is staring them in the face is that the mad race to ever-higher returns on equity is finished. The days of 15%, 20% or even 30% ROEs are coming to a close, and eventually corporations will be bragging about their 5% ROEs. This is perhaps the most painful adjustment of all, because it hits corporate executives right in the pocketbook. Much smaller ROEs will lead inevitably to much smaller executive paydays.
All of these pressures on corporate performance will sooner rather than later push the Dow closer to 6,600 rather than 14,000. And when 6,600 is broken, what then? Between Dow 1,000 to Dow 6,600, there are no natural buyers of stocks, because the move up from 1,000 was a moon shot straight through the Reagan, Bush I, and Clinton years. There was no significant consolidation in the markets during this entire period, which says that the market is well overdue to revisit this area, and perhaps retrace the move all the way back to Dow 1,000.
Most people, especially professionals in the market, think it preposterous that the Dow could fall as low as 1,000. That level was last seen at the very start of the Reagan years. But think about it: the market has already begun to unravel the great credit boom that began under Reagan and continued all the way to 2007. The total level of credit available to the US economy is shrinking to what was normal in the 1980s, and corporate profits are shrinking accordingly.
The standard of living for the average American is collapsing as well, especially for the baby boomers who have no money saved for retirement other than some worthless tech stocks and an overvalued home. Why shouldn’t the stock market adjust in a similar manner? The Dow has already lost about 8,000 points from its peak when it fell to 6,600, so what are 5,600 points more?
For the moment, the idea of the Dow at 1,000 seems fantastical and absurd, but if and when it happens (and the odds favor when, not if), everything will look perfectly sensible afterward. We will all wonder why the Dow could possibly ever have traded above 10,000, and why we didn’t sell our shares back then when we had a chance. But of course, who was going to sell their shares on an idea that back then was considered fantastical and absurd?
Dow May Crash to 7,500 If 10,600 Not Breached
by Daryl Guppy - CNBC
Seeing there's been quite a bit of interest in my recent comments on CNBC about the historical parallels between the Great Depression and the recent financial crisis, I thought it may be appropriate to elaborate further on the chart technicals behind the observation.
The causes may have been different, but the collapse of the U.S. markets in early 2008 followed the same behavioral patterns as the collapse in 1929. The recovery pattern seen in 2010, is also very similar to that developed in 1930.
The crash of the Dow Jones Industrials in 1929 was signaled by the development of a well defined head and shoulder pattern, seen most clearly in its monthly chart. It is a reliable pattern that captures the behavior of investors who are becoming increasingly disillusioned about the future prospects for economic growth.
The downside pattern targets in the 1929 Dow were exceeded with a fall of around 49% before the market recovered in 1930. The 2008 dow pattern targets were also exceeded with a market fall of around 52%.
In 1930, the market developed an inverted head and shoulder rebound pattern recovery that led to a 46% rise in the market. The Dow rebound in 2009 also developed from an inverted head and shoulder pattern. This was a powerful rise of around 69%.
The historical development of the recovery in the DOW in 1930 ended with a new head and shoulder pattern. This was followed by a rapid market decline that created the first part of a long term double dip pattern. This retreat also exceeded the pattern projection targets with a fall of 28%.
Fast forward to today, we're seeing the Dow is developing a new head and shoulder pattern which indicates a beginning of a bear market. The rally peaks in the Dow appear in January and May and June. The downside projection taken from the neckline of the pattern sets a target at 8,400, or a 25% decline.
A very bearish analysis using the pattern of retreat behavior in 1930 suggests the Dow could retreat to around 7,500 in 2010.
The head and shoulder pattern in the Dow and its downside targets, are invalidated with a sustainable rise above 10,600. A move above this level does not signal a resumption of the uptrend, but it does reduce the probability of a double dip.
It must be noted that while the behavioral patterns in 1930 and 2010 are similar, they don't necessary point to the same result. But it does sound a warning that markets could continue to stand on the edge of a precipice.
We Can’t Afford This House
by Christopher Papagianis And Reihan Salam - National Review
At the end of June, the House of Representatives voted to extend the $8,000 homebuyers’ tax credit, by an extraordinary margin of 409–5. The Senate approved the measure on a voice vote. At a polarized political moment, this near unanimity was noteworthy in itself. Conservative Republicans and liberal Democrats, from cities and suburbs and small towns across the country, joined together to shower a bit more taxpayer largesse on one of America’s favorite industries: real estate. But there’s a problem with this bipartisan idyll.
Though the homebuyers’ credit was sold as a stimulus measure, we have no reason to believe that it is anything other than another wealth transfer to a large and powerful industry, one with allies conveniently situated in every congressional district. Casey Mulligan of the University of Chicago has suggested that the credit had almost no economic impact. As Harvard economist Edward Glaeser observed, it did little more than create an incentive for "mindless house swapping." It didn’t even have a meaningful impact on the behavior of first-time homebuyers — people already planning to make purchases simply moved them forward a few months.
Yet this is where we find a consensus in policymaking: We can’t agree on balancing the budget or reforming entitlements or the tax code, but we can agree to churn the housing market so that a handful of real-estate agents can make a buck on commissions while the economy crumbles. Across the world, governments have spent vast sums on doomed industrial policies. We often hear about the occasional success of efforts in East Asia to nurture shipbuilding and automobile manufacture and electronics. But we don’t hear about the countless failures, in which cronies of the party in power receive endless subsidies and concessions, getting richer at the expense of the economy as a whole.
In the United States, our industrial policy for most of the last century has been centered on housing. Tax subsidies and the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac have helped channel hundreds of billions of dollars into housing. There was a certain logic, however flawed, behind this policy. As opportunities for less-skilled workers declined, construction jobs provided a much-needed income boost to many working- and middle-class households. But like any arrangement built on government favoritism, this one was bound to fall apart. Long-term unemployment has skyrocketed in no small part because of the evaporation of construction jobs that date from the overbuilding that occurred during the bubble years.
What we need now is to turn away from this disastrous policy and find new, sustainable sources of jobs and economic growth. That will require a series of painful steps — among them, phasing out the mortgage-interest deduction and eliminating the GSEs — that will minimize the privileges housing enjoys relative to investments in other industries. By shifting resources from housing to more productive sectors, we will have higher and more sustainable growth. With trillions of dollars and the health of the economy at stake, the question isn’t whether we must do it, but whether we will do it now or wait until our economy is in even worse shape.
The basic argument for housing subsidies is that homeownership allows Americans of modest means to accumulate wealth. From the New Deal on, the federal government has played a decisive role in the mortgage marketplace. As journalist Alyssa Katz recounts in her 2009 study of the housing industry, Our Lot: How Real Estate Came to Own Us, homeownership was far less common in the United States of the 1920s than it is today. Borrowers had to make down payments that approached half the purchase price of a house to secure a three- to five-year mortgage. For families without enough savings, there was a market in second mortgages to finance down payments, at startlingly high interest rates.
As housing prices collapsed with the onset of the Great Depression, millions found themselves underwater, and this created intense pressure for what we might reasonably call a government takeover of the mortgage industry. The political case for federal intervention was strong. Americans had come to believe that homeownership was essential to economic security and that it made for better citizens. Research had found that housing was a particularly important component of total wealth accumulation for lower-income households and suggested that it led to improved educational outcomes. The portion of the monthly mortgage payment that pays down the principal constituted a source of savings for households that were unlikely to have other significant savings or investments.
The high down payments and short-term mortgages meant that households all over the country held a significant amount of equity in their homes just a few years after buying them. In some cases, the value of this equity grew as the value of the home appreciated. These capital gains, in conjunction with the forced savings of mortgage payments, meant that millions of families had assets they could pass on to future generations. The New Dealers believed this was the path industrial workers could take to reach the independence once associated with prosperous ranchers and farmers in the American West.
The formula, however, changed dramatically at the end of the 20th century. From 1994 to 2005, the homeownership rate reached record highs, thanks largely to innovations in the mortgage-finance market that reduced down payments and minimized equity. This shifted the basic wealth-building proposition of homeownership away from savings to an almost exclusive focus on capital gains. Average down payments fell, reducing the savings required to "get in the door."
More significant was the rise of mortgages that involved no forced savings: the interest-only loan, in which no equity is built because the principal is never paid down, and the "negative amortization" loan, in which payments are so low that they do not even keep up with the interest, leaving homeowners more indebted, rather than less, each month. By 2006, more than one-third of subprime mortgages had amortization schedules longer than 30 years, nearly half of Alt-A mortgages were interest-only, and more than one-fourth were negative-amortization loans.
One effect was to reduce the social benefits of homeownership, because the benefits are a product of equity and not of the mere fact that a contract has been signed and a mortgage taken out. The relationship between homeownership and social goods had been misunderstood: The traits that enabled households to build up the savings necessary for significant down payments — hard work and the deferral of gratification — were misattributed to homeownership itself. Paying a mortgage did nothing to improve children’s educational outcomes; instead, the factors that gave rise to homeownership also led parents to raise children in a manner that led to greater educational attainment.
Without substantial down payments and conservative amortization schedules, the entire proposition of homeownership as a social good is turned on its head. Think of a homeowner with a zero-down, negative-amortization mortgage: The balance would equal at least 100 percent of the value of the house at origination and would steadily grow, putting him ever deeper in debt unless the market value of the house grew at an even faster rate. Rather than being a source of wealth, the mortgage would actually reduce the net worth of this homeowner below what it would have been had he rented.
Rather than providing a social benefit, then, homeownership without equity imposes costs. Andrew Oswald of the University of Warwick has argued that such homeownership can exacerbate unemployment by making workers less likely to move from one labor market to another. Labor mobility is badly undermined when homeowners in a depressed market can’t sell their property for anything approaching the principal balance of the mortgage they originally took out to buy it.
The macroeconomic consequences of this shift toward low-equity homeownership are visible in research from the Federal Reserve that examines the assets and liabilities of U.S. households. In the first quarter of 2001, U.S. households’ home equity stood at $7.7 trillion, or 61 percent of the value of all residential real estate. By the third quarter of 2008, it had declined to $7.6 trillion, even as outstanding mortgage debt increased by $5.6 trillion over the same period. By the first quarter of 2009, home equity was $1.35 trillion lower than it had been in 2001. Put another way: Despite the housing boom, the portion of residential real estate actually owned by households declined. This means that the increase in homeownership rates (and the subsequent rise in housing prices) was entirely debt-financed.
These developments provide important lessons for policymakers. First, subsidies designed to turn renters into homeowners likely did harm to many households, given that home equity declined over the 2001–09 period. Second, there was a reduction in real mortgage rates, thanks to the subsidies provided by the GSEs, the Federal Housing Administration (FHA), and the tax code. By increasing households’ purchasing power, such measures drive up the prices of homes — over the period in question, by as much as 25 percent — without doing anything to encourage real affordability.
This is why homeownership rates in Canada and in European countries that do not offer a mortgage-interest deduction are roughly the same as in the United States. While ending these subsidies would probably not alter homeownership rates, it would likely shift capital away from artificially bid-up residential real estate to more productive uses.
Admittedly, ending the subsidies would probably depress housing prices overall. Since most homebuyers base their purchase decisions on the monthly after-tax cost of housing, reducing the deduction for mortgage interest would mean that the same monthly payment would buy "less house." For example, a 25 percent deduction for mortgage interest allows buyers with a 6 percent mortgage to spend an extra $30,000 on a house without seeing any increase in their monthly payments. Similarly, an increase in down-payment requirements from the current 3.5 percent to 20 percent would mean that $20,000 of savings could be used to buy only a $100,000 house, rather than one priced at $570,000.
A general decline in housing prices would constitute a one-time wealth transfer from current homeowners to future ones — but this would be well worth it if phased in over a period of years. In 2007 (the last year of the bubble), households’ primary residences accounted for only 31.8 percent of total family assets. While primary residences make up a larger share of the assets of lower-income than of higher-income households, housing subsidies are less significant for the former because their tax rates are lower, which makes the value of deductions smaller.
Because the value of subsidies provided by the FHA and the GSEs accrues to the borrower on a per-dollar-of-debt basis, their reduction is unlikely to be felt as strongly by lower-income households. The well-off take out bigger mortgages, pay more interest, and have bigger income-tax bills against which to apply a deduction: The median house value for households in the 40th through the 59th income percentiles is just $150,000, compared with $500,000 for households in the top income decile.
According to the Office of Management and Budget (OMB), the mortgage-interest deduction is expected to cost $637 billion over the five years ending in 2015. The exclusion of capital gains on primary residences is expected to cost another $215 billion over the same five years, with the deductibility of state and local property taxes on owner-occupied homes adding $151 billion. In total, these subsidies will reduce federal revenue by well over $1 trillion over a decade during which the federal government is expected to run a $9 trillion deficit. A gradual phase-out of these subsidies is therefore not only smart economics, but a fiscal necessity.
Over the years, tax experts have also zeroed in on how some of these subsidies are distributed. Under the status quo, 80 percent of the benefits from the mortgage-interest deduction go to the top 20 percent of households in terms of income. The deduction helps only those taxpayers who itemize deductions on their tax returns, which is much more common among high earners, and the value of the subsidy rises as one moves up the tax brackets. Further, as Joseph Gyourko and Todd Sinai of the University of Pennsylvania have documented, the subsidies are unevenly concentrated, with net benefits going to only 20 percent of states and 10 percent of metropolitan areas.
Not surprisingly, over 75 percent of these benefits go to three high-cost metropolitan areas: New York City–Northern New Jersey, Los Angeles–Riverside–Orange County, and San Francisco–Oakland–San Jose. A better approach would be to provide a flat tax credit to all homebuyers. This would preserve an incentive for people to buy a home but would not provide a larger incentive for people who buy bigger homes or take on outsized debts. The size of the credit could be reduced over time. Under this sort of policy, the federal government could aid middle- and working-class homebuyers at a small fraction of the cost of the current mortgage-interest deduction.
Dismantling the GSEs is a more difficult proposition. Taxpayers have already committed roughly $150 billion to the bailout of Fannie and Freddie. The Congressional Budget Office projects that losses could balloon to $400 billion over time, while other analysts suggest the taxpayer hit could be closer to $1 trillion if default and foreclosure rates stay high. The reason these estimates vary so much is that taxpayers can expect three different kinds of losses from the GSEs: those linked to the $5 trillion of mortgage-backed securities and loan guarantees that they are responsible for; those that will continue to occur as a result of regular, ongoing operations in a declining housing market; and those that may result from their being used as de facto government agencies, subsidizing foreclosure-prevention efforts.
Fannie and Freddie function today as off-balance-sheet conduits for taxpayer spending on housing, and there is no mechanism in place to end this practice. What’s particularly disappointing is that Congress is on the verge of sending the president a sweeping financial-reform bill that doesn’t account for Fannie and Freddie, the most expensive part of the bailouts.
A lot of thoughtful proposals for reforming Fannie and Freddie have been issued over the past year. In late May, Donald Marron and Phillip Swagel of Georgetown University put forth one of the more balanced and straightforward plans. The crux of it is to make the GSE guarantees explicit rather than implicit, and to charge an appropriate fee for them. Marron-Swagel would turn Fannie and Freddie into private companies and force them to compete with other firms. These new businesses would have a narrow mission: to buy conforming mortgages and bundle them into securities that are eligible for government backing. The key is that the federal guarantee would be transparent, and offered only in exchange for the firms’ paying the government an actuarially fair price for what would amount to insurance.
An explicit government backstop might seem an unwarranted interference in housing markets, but recent experience suggests that it is unrealistic to believe that the government will stand aside next time. Some government backstop will always be implicit; better to make it explicit and price it. Once a price is established under the Marron-Swagel plan, the government would have the option of raising it, thereby reducing its support for the market, slowly and over time.
The government could also reduce its footprint in the housing market by putting a ceiling on the size of the mortgages eligible to be packaged into government-backed securities. If the loan limit were capped in nominal terms, then future inflation and house-price increases would, over the course of several years, work to reduce the government’s presence in the marketplace.
Likewise, other subsidies, such as the mortgage-interest deduction, can and should be gradually eliminated. Reforming the housing sector won’t miraculously restore robust economic growth. It will, however, help stanch the bleeding of productive resources into a sector that has been distorted for decades by misguided government subsidies. And over time, that will give workers and entrepreneurs the tools they need to build a stronger and more sustainable economy.
Jeremy Grantham: Deflation has won on points
by Edward Harrison - Credit Writedowns
Well, I, for one, am more or less willing to throw in the towel on behalf of Inflation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the "flation" issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or flat prices are the prospect for the immediate future.
Yep, that’s exactly it, isn’t it? Deflation is winning. This passage is how Jeremy Grantham begins his latest Quarterly Letter. In describing this Battle Royale between inflation and deflation, in June of 2009 I said Central banks will face a Scylla and Charybdis flation challenge for years. My thinking was the deflationary forces of deleveraging would be counteracted by the inflationary forces of monetary and fiscal stimulus for years to come.
However, as 2009 progressed, I started to see the macro picture differently. I certainly developed "bailout fatigue" myself. However, as I expressed it in November, so had everyone else. The money printing, liquidity programs, bailouts, the record bonuses, the lack of credit availability combined with the unemployment, foreclosures, and the acrimony over health care to discredit stimulus.
[P]eople were swayed toward Big Government because of a deep downturn and financial crisis but crony capitalism and bailout fatigue have discredited Big Government. And now we are witnessing a war about the proper role of government. Perceptions of recent policy decisions remain top of mind in the process.
-A few thoughts about the limitations of government, Nov 2009
Here we are two-and-a-half years after the recession began with underemployment in the high teens, record foreclosures, contracting credit, a slowing economy and fears of a double dip. Yet, a lot of people are talking about austerity – as if that wouldn’t tank the economy. Some people forget, even Obama was talking this way in November. It was right then I knew that deflation was going to win.
So why do we see the sudden switch to austerity mode and the attendant slowing it will induce? The deflationary forces are winning because people have had their fill of the policy choices that have led us to where we are today. I agree with Krugman that Clive Crook’s comments on this are misguided. Obama has overpromised and undelivered. It’s as simple as that. You have what I would call crony capitalism on the one side with bailouts and record bonuses all around for bankers. Juxtaposed are massive budget deficits and a still weak economy and employment outlook. No one is going to double down on that strategy. It’s a failure – and I would argue that it is because there was insufficient stimulus. All of this was predictable from the word go.
Where do I stand on these issues now? The euro zone is bound by the euro gold-standard strictures which force a deflationary economic policy onto the euro nations. So austerity-lite is a minimum requirement all around. And while the Germans claim they have the least austere budget in the euro zone for 2010, they too should be afraid of running budget deficits of 5% of GDP given their near 80% government debt to GDP.
In the UK and the US, government has more leeway. I don’t support austerity. I would like to see more stimulus but I can’t support a lot more stimulus if the goal is to maintain high levels of resource allocation in financial services. Where are the new jobs going to come from if the government is propping up the housing sector? Where are new jobs going to come from if credit availability is weak as the government aides and abets banks in hiding losses? Trying to prop up malinvestment only lengthens the downturn.
Picture this: Ben Bernanke announces a plan to buy up $2 trillion more in mortgage-backed securities. Maybe he buys some municipal bonds as well. We extend unemployment benefits, keep interest rates low and the yield curve steep. Meanwhile the Obama administration gets trillions of dollars in new money for shovel ready projects? Now, fast forward to early 2012: what do house prices look like? How about bank balance sheets? How about private sector debt loads?
There would still be a too many people employed in the financial sector. House prices would be above median levels on long-term price to income charts. And I guarantee you there would be little household sector deleveraging. How is early 2012 then any better than mid-2010 on any of the longer term metrics we care about?
I’ll answer that. Unemployment would come down I bet and bank balance sheets would be marginally better. But household debt levels would still be large and bank balance sheets would be relatively weak on a mark-to-market basis. The demand for and availability of credit would therefore be weak. This is a muddle through scenario at best. Would we be closer to our goal of reduced private sector leverage? Yes. The cost of that deleveraging would be much greater government debt. In essence, we would have socialized the losses which would accrue to debtors and their creditors in a more deflationary scenario. Deficits might ease with recovery but they would still be large. And this would continue for a number of years more.
I don’t think you can add huge amounts of stimulus to an economy without significant malinvestment which would retard longer-term growth rates. This is what I said about eastern Germany. I still think having a 200% debt to GDP ratio like Japan is a bad thing. And I don’t think we can close the output gap without increasing the debt to GDP ratio to Greek levels. I also don’t think the potential growth rate in an ageing society will be sufficient to ever reduce the debt to GDP ratio without inflation boosting nominal growth rates. Where does that leave us then?
I think it leaves us in a situation where deflationary forces prevail for the medium-term. Grantham says deflation has won on points. Radio Raheem would say "Left hand inflation KO’ed by deflation."
And I think they will continue to win until the output gap closes, when the left hand will be back.
Pimco Sells Black Swan Protection as Wall Street Markets Fear
by Shannon D. Harrington, Miles Weiss and Sree Bhaktavatsalam - Bloomberg
Wall Street’s hottest new product is fear. Almost two years after Lehman Brothers Holdings Inc.’s failure caused world markets to seize up, Pacific Investment Management Co. is planning a fund that will offer protection to investors against market declines of more than 15 percent. Morgan Stanley strategists estimate demand for hedges against such cataclysms helped drive as much as a fivefold increase last quarter in trading of credit derivatives that speculate on market volatility.
The efforts to protect against another disaster, which helped drive up the relative costs of the most bearish credit derivatives to the highest in two years, show that investors’ psyches still haven’t recovered from the Lehman bankruptcy on Sept. 15, 2008, which erased $20.3 trillion in stock market value worldwide and caused credit markets to freeze. "Everyone is starting to realize that this is going to be a much longer, much more difficult path to recovery," said William Cunningham, head of credit strategies and fixed-income research at Boston-based State Street Corp.’s investment unit, which oversees almost $2 trillion. "It’s really quite fragile and vulnerable in a way that we haven’t seen in our lifetime."
Demand for protection against so-called tail risks, extreme market moves that Wall Street’s financial models fail to detect, is increasing as investors react to events such as the May 6 stock market rout that briefly sent the Dow Jones Industrial Average down almost 1,000 points, or Greece’s sovereign debt crisis, which on June 7 sent the euro to a four-year low against the U.S. dollar.
For much of the year before Lehman’s collapse, Nassim Nicholas Taleb warned bankers that they relied too much on probability models and had become blind to potential catastrophes, which he labeled black swans, a reference to the widely held belief that only white swans existed -- until black ones were discovered in Australia in 1697. His 2007 book, "The Black Swan," contends tail risks are becoming more severe.
To hedge against tail risks, investors usually look for the cheapest insurance against a cataclysmic market sell-off, mainly through derivatives that are expected to multiply in value as prices plummet for everything from stocks to the Australian dollar. The Indiana Public Employees Retirement Fund, with $14.1 billion of assets, asked financial institutions in January to send information on a tail-risk management program that would protect it against "an extreme market downturn," according to a request for information on the manager’s website.
The term long-tail risk is derived from the outlying points on bell-shaped curves that forecasters use to plot the probability of losses or gains in a given market. The most probable outcomes lie at the center. The least probable, such as a decline of 5 percent in an index that most days rises or falls by less than 0.25 percent, are plotted at the "tails" of the curve. The greater the deviation, the longer the tail.
Taleb helped pioneer tail-risk hedging in the 1980s, trading options for banks including First Boston Inc., now part of Credit Suisse Group AG. Taleb built what he later termed a "massive" position in options on Eurodollar futures when the stock market crashed on Oct. 19, 1987. The Dow’s biggest one-day drop in history prompted the Federal Reserve to pump liquidity into the banking system, lowering interbank borrowing rates and causing the futures to surge.
'Drop Like Flies'
Pimco, manager of the world’s biggest bond fund, Deutsche Bank AG and Citigroup Inc. are among firms offering clients tail-risk protection, either through funds or traded instruments that act as hedges. Taleb said few will have the stomach to stick with the strategy. "They will drop like flies," said Taleb, now a professor at New York University’s Polytechnic Institute, who in 1999 set up tail-risk hedge fund Empirica LLC, which he ran for six years. "They and their customers will give up at some point. I’ve seen it before."
Besides the sovereign debt strains in Europe that led to Greece, Spain and Portugal having their credit ratings reduced, investors such as Kyle Bass, who made $500 million three years ago on the U.S. subprime collapse, are concerned that even top- ranked governments may face hyperinflation from bailing out the global financial system. The U.S. has $8 trillion of public debt outstanding, up from less than $4.5 trillion in mid-2007. China is grappling with a property bubble as its world- leading 11.9 percent economic expansion slows. Prices in 70 cities rose 11.4 percent in June from a year earlier following a record 12.8 percent in April and 12.4 percent in May, according to China Information News.
At the same time, traders say that market liquidity, or the ability of investors to easily trade in and out of positions as markets change, hasn’t fully recovered from the Lehman collapse. Even though the amount of Treasuries outstanding has increased about 75 percent the past three years, the average daily trading volume of the securities among the primary dealers has declined about 12 percent, according to Fed data.
"In some of these asset classes, it’s just not practical to reduce risk by selling given the lack of risk appetite and illiquidity," said J.J. McKoan, co-director of global credit investments in New York at AllianceBernstein LP, where he helps manage $199 billion in fixed-income assets.
Investors were reminded that the improbable can happen by the events of September 2008 -- from the government seizure of mortgage-finance companies Fannie Mae and Freddie Mac to Lehman’s bankruptcy and the near-failure of American International Group Inc., once the world’s largest insurer. Defaults on mortgages given to the least creditworthy borrowers drove financial institutions worldwide to take $1.8 trillion in writedowns and losses.
The seemingly growing occurrences of events that fall on the fringes of probability are prompting pension fund managers and other institutional investors -- who once shunned costly hedging strategies -- to reconsider. And they’re doing it even as economists predict the U.S. economy will grow an average of almost 3 percent through 2012 and as analysts forecast the Standard & Poor’s 500 Index will gain 17 percent through year- end. "People are trying to move beyond historic notions that tail risk events are so infrequent on the one hand, and so extreme on the other hand, that there is nothing you can do about them," said Eugene Ludwig, who started a Washington-based risk management firm called Promontory Financial Group after serving as U.S. Comptroller of the Currency under former President Bill Clinton.
Pimco Chief Executive Officer Mohamed El-Erian developed tail-risk strategies when he was manager of Harvard University’s endowment in 2006 and 2007, and wrote about the importance of such hedging in his book, "When Markets Collide." El-Erian, who describes America’s economic future with the term "new normal," advocated the strategy he applied at Harvard on returning to Pimco in January 2008.
Pimco, which manages about $1.1 trillion, opened its first mutual fund aimed at minimizing risks from systemic shocks that October. The Pimco Global Multi-Asset Fund is co-managed by El-Erian and Vineer Bhansali. Pimco, the Newport Beach, California-based investment firm that runs the $234 billion Total Return Fund, is using strategies in many of its funds to protect against tail events, said Bhansali, chief architect of the company’s tail-risk management program.
"You don’t want to try to be too smart in trying to forecast what is going to happen and which hedge is going to perform better," said Bhansali, who holds a doctorate in theoretical particle physics from Harvard in Cambridge, Massachusetts, and ran the exotic and hybrid options trading desk at New York-based Citigroup. "What you want to do is accumulate cheap protection." The Pimco Tail Risk Hedging Fund 1 will be the first in a potential series of partnerships, according to a private placement filed with the U.S. Securities and Exchange Commission on June 23. The initial fund will be designed to protect investors from a drop of more than 15 percent in a benchmark index that Bhansali declined to identify.
Deutsche Bank is marketing a tail-risk hedging index that gains in value when investor expectation of stock-market volatility increases, according to material the bank sent to clients. The so-called Equity Long Volatility Investment Strategy, or ELVIS, uses derivatives called variance swaps linked to the S&P 500 that bet on the index’s volatility. Derivatives are contracts whose value is tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.
Citigroup hired John Liu, a former employee of the Indiana pension fund, about two months ago for a newly formed unit that will advise pension plans, endowments and foundations on tail risk hedging, according to a prospective investor who declined to be named because the hire hasn’t been publicly announced.
Liu was formerly the managing director of equity strategies at Vanderbilt University, the Nashville, Tennessee-based college that in late 2005 tried to hedge portions of its endowment by using tail-risk insurance. "This has become something of a ‘me-too’ trade lately," said Mark Spitznagel, a former Taleb trading partner at Empirica, who now runs Santa Monica, California-based Universa Investments LP, which Taleb advises. "These guys are all very new to a difficult game that we’ve been playing for a very long time now."
Along with the demand, the costs of tail-risk hedging have also climbed. In June, investors buying options that paid off should the S&P 500 plunge more than 23 percent from its April high were paying 75 percent more than those speculating on gains. The premium was the highest ever, according to data compiled by Bloomberg and OptionMetrics LLC. Options give investors the right to buy or sell shares at a predetermined price.
The risk premiums that investors were willing to pay for the most bearish options on a European credit index rose to the most since before Lehman’s collapse. The so-called three-month volatility skew, a measure of the risk premium for options trading far from their strike price -- known as out-of-the-money -- versus those trading close to the strike, reached 30 percentage points on June 4, the highest in at least two years, and up from 5 percentage points at the end of 2009, Goldman Sachs Group Inc. data show. The skew has since fallen back to 9 percentage points. In absolute terms, the cost of an out-of-the-money four- month option giving the right to buy protection against default by 125 European companies was $930,000 for a $100 million trade in May, compared with $630,000 yesterday.
Goldman Sachs strategists said last month that investors were overpaying for the derivatives as fears of a sovereign default in Europe became too extreme, and not paying enough to hedge against higher-probability scenarios such as a prolonged period of low growth that spares the financial system while causing a jump in defaults among the lowest-rated borrowers.
"To put it into sailing terms, investors are paying a high premium to hedge against a sudden storm," Goldman Sachs strategist Alberto Gallo in New York said. "But they’re not willing to hedge against a prolonged period of no wind. This creates a buy opportunity for credit." Trading in options used to speculate on price swings in benchmark credit-default swap indexes rose as much as fivefold last quarter from the beginning of 2010, according to estimates of activity at Morgan Stanley, said Sivan Mahadevan, global head of equity and credit derivatives strategy at the firm in New York.
"It’s one of the most significant credit developments since 2008," Mahadevan said. "Investors can’t just think of credit as being a low volatility asset class anymore." Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. Investors should be cautious in following the herd, said Eric Petroff, director of research at Wurts & Associates, a Seattle-based consulting firm that oversees about $30 billion on behalf of institutional investors. "Products that protect you from tail risk tend to crop up after the tail has occurred," he said. "Back in 2007, it made a lot of sense to hedge tail risk but now it just seems brilliantly misguided."
Other asset managers that have been hedging against improbable events are creating funds to take advantage of demand. Pine River Capital Management LP, a Minnetonka, Minnesota, firm that has $2.1 billion in assets under management, started the Nisswa Tail Hedge Fund LP last month, according to a June 15 filing with the SEC. The partnership was formed at the request of investors who wanted access to the hedging techniques used by Pine River’s primary multi-strategy fund, which gained 40 percent during 2008 and 2009, according to Aaron Yeary, a co-founder.
"By buying prudent hedges and staying liquid, it allowed us to be on the offense during the crisis," said Yeary, who is running Nisswa Tail Hedge with Nikhil Mankodi. "Some sold their liquid investments and were left with garbage," Yeary said, adding that Nisswa Tail Hedge has about $200 million in assets.
Capula Investment Management started a tail-risk fund in March with about $100 million, which has grown to about $650 million, according to a person familiar with the fund, who declined to be identified because the fund details are private. It may top $1 billion in the next two months, the person said. Ionic Capital Advisors LLC, a New York-based investment firm founded by former employees of Highbridge Capital Management LLC, is offering tail risk protection through Ionic Select Opportunities Fund LLC, according to a private placement notice filed with the SEC on June 11. Mary Beth Grover, a spokeswoman for Ionic, declined to comment.
Taleb said sticking with a tail-risk strategy can be psychologically challenging because payoffs, while big, are less frequent. "If you looked at numbers over a period of time -- six, seven, eight years -- there’s much higher return," Taleb said. "But if you watch a trader in any given year, he looks like an idiot. No trader wants to feel like he’s an idiot."
Report Says Jobs Hole Could Persist For A Decade
by Arthur Delaney - Huffington Post
The U.S. Senate's epic struggle just to reauthorize unemployment benefits for the long-term jobless suggests that policymakers in Washington fundamentally don't understand the jobs hole we're in, according to a team of trained economists. The progressive Center for Economic and Policy Research reports that it could take an entire decade for the national unemployment rate to come down to pre-recession levels.
"Between December 2007 -- the official first month of the recession -- and December 2009, the U.S. economy lost more than eight million jobs," write CEPR's John Schmitt and Tessa Conroy. "Even if the economy creates jobs from now on at a pace equal to the fastest four years of the early 2000s expansion, we will not return to the December 2007 level of employment until March 2014. "And, by the time we return to the number of jobs we had in December 2007, population growth will have increased the potential labor force by about 6.5 million jobs. If job growth matched the fastest four years in the most recent economic expansion, the economy would not catch up to the expanded labor force until April 2021."
Here's a dramatic chart from CEPR showing the total number of jobs lost since the recession began:
Why the financial reform bill won't prevent another crisis
by William K. Black - Fortune
Financial regulators, white-collar criminologists, and economists all agree that perverse incentive structures cause crises and they agree that the finance industry's incentive structures have long been perverse. The Obama administration asserts that the financial reform bill the President will sign into law this week will prevent future crises. In fact, it will fail to do so because it does not effectively address those perverse incentives. Indeed, it increases the likelihood of the accounting scams that are the very reason why perverse incentives pay.
Over time, crises have gotten more severe because many reform policies have the unintended consequence of encouraging these types of incentive structures. Executive and professional compensation create the motives, while deregulation, desupervison, and regulatory "black holes" create the opportunity. Accounting is the CEO's "weapon of choice" that transforms the perverse incentive into what economists, regulators, and criminologists agree is a "sure thing" in crises (means). That's the classic recipe for disaster: motive, means, and opportunity.
The reform bill falls short
The bill does not address the problematic nature of modern executive and professional compensation even though the data shows that these are leading causes of the Great Recession. The percentage of executive compensation tied to short-term reported income has increased since the crisis, according to an independent study by James F. Reda & Associates. Accounting is a "sure thing" when it comes to creating whatever short-term income the CFO and CEO desire to report.
Professional compensation is an endemic disaster, and no one who is honest denies it. Have a CDO backed by "liar's loans" that doesn't warrant even a single "C" rating? You could get any of the top rating agencies to give you an "AAA." Your lawyer would structure the CDO for you, and the internal and outside auditors would bless it. The underlying mortgages rested on multiple scams by professionals. The loan brokers and officers' bonuses led them to advise to file fraudulent applications and caused them to ensure that appraisers were picked that would inflate "market values." "Independent professionals" were suborned in this manner well over a million times.
Studies show that college students are frequently willing to cheat on tests and to refuse to report cheating by others. Why are economists unwilling to understand that these same people often continue to cheat as VPs and CEOs? They prosper because they cheat. Andrew Fastow became Enron's CFO, and was named "CFO of the Year" by CFO Magazine because he was willing to help Lay and Skilling loot Enron via accounting fraud. The title of George Akerlof and Paul Romer's classic 1993 article says it all - "Looting: Bankruptcy for Profit." (Akerlof was awarded the Nobel Prize in Economics in 2001.)
The Basel II international bank capital rules encouraged the biggest banks to use proprietary models to value their own assets. The quants got bigger bonuses if the models produced larger asset values. It tells you something when the trade calls these scams "mark to myth" and "liar's loans." It tells you even more when the reform bill does not make ending these perverse incentives its primary task.
The reform bill fails to address the role of accounting in providing the "sure thing" means for senior officers to exploit and profit personally from these perverse incentives. The financial industry used its lobbying power to induce Congress to extort FASB to change the accounting rules to hide mortgage losses. This is the (early) S&L and the Japanese strategy of the cover up. It leads to disaster (S&Ls) or lost decades (Japan).
Without honest valuations, markets do not clear and the economic recovery will continue to be weak and fragile. It is vital that this cover-up ends immediately. The reform bill, however, permits greater accounting abuses to encourage a cover up. Reform bill proponents cite the resolution authority as the key advantage of the bill, but that is disingenuous. The regulatory hole in resolution authority was filled over 18 months ago when investment banks became regulated as commercial banks. Presidents George W. Bush and Barack Obama had adequate authority to close the major insolvent banks, a statutory duty to do so (under the Prompt Corrective Action Law of 1991), and the factual basis (insolvency) for appointing receivers.
But the administrations lacked the will, political courage, and the integrity to close the major insolvent banks. They evaded the mandates of the Prompt Corrective Action Law by encouraging the largest banks not to recognize their massive losses on bad loans and CDOs.
William K. Black is an Associate Professor of Economics and Law at the University of Missouri-Kansas City. He is also a white-collar criminologist and a former senior financial regulator and the author of "The Best Way to Rob a Bank is to Own One."
SEC's Demand That Goldman Admit 'Mistake' Could Spur Wall Street Lawsuits
by Jesse Westbrook and Joshua Gallu - Bloomberg
By forcing Goldman Sachs Group Inc. to admit a "mistake," U.S. regulators may be signaling a more confrontational approach to future settlements that could expose Wall Street to more investor lawsuits.
In its $550 million accord with Goldman Sachs, the Securities and Exchange Commission deviated from its usual practice of imposing a fine while letting a firm remain silent on whether it engaged in misconduct. Firms that are required to admit oversights may find it difficult to argue in private litigation that they conceded no wrongdoing and settled purely to end regulatory scrutiny, said Salvatore Graziano, a lawyer who specializes in class-action suits on securities fraud. "This makes it even harder to assert that they settled out of convenience," said Graziano, of Bernstein Litowitz Berger & Grossmann LLP in New York. "Once it’s out there, it’s out there."
Last week’s accord between New York-based Goldman Sachs and the SEC removed a cloud over Wall Street’s most profitable firm. The SEC accused Goldman Sachs three months ago of selling a mortgage security without disclosing that hedge fund Paulson & Co. helped design the asset and was betting it would fail. While Goldman Sachs still used the boilerplate language of not acknowledging or refuting improper conduct, the company also said it was a "mistake" that its marketing materials for the security called Abacus 2007-AC1 included "incomplete information." The documents didn’t include Paulson’s role, according to the SEC settlement. The mistake admission was limited to the Abacus deal.
The demand that Goldman Sachs admit an error is a "major departure" for the SEC, said Harvey Pitt, a former chairman of the agency. "I don’t believe this will reflect a broadside decision to require concessions, because if that occurred, the SEC might not be able to settle a large percentage of the cases it brings," he said. "Given the limits of the SEC’s budget, it is clearly not able to litigate every case it might otherwise bring."
The SEC has about 1,400 employees in its enforcement division, which investigates and prosecutes wrongdoing. The entire agency operates on a budget of about $1 billion a year. Goldman Sachs has more than 34,000 employees and earned $4 billion in the first six months of 2010. Companies and individuals that forge settlements with the SEC benefit from not having to admit wrongdoing, because it can limit their legal exposure, said Michael Piazza, a former SEC lawyer. The lack of any concession gives criminal prosecutors and private litigants nothing to build cases on, Piazza said. It also reduces the likelihood that insurance companies will deny paying lawyer fees on the basis that an SEC target is admitting guilt, he said.
'World Will Change'
"An acknowledgment of some wrongdoing or specific acts of facts alleged could have a very different effect," said Piazza, who now represents targets of SEC investigations at Greenberg Traurig LLP in Irvine, California. If the Goldman Sachs case "portends a trend for more fulsome acknowledgements, the world of SEC settlements will change."
Goldman Sachs on April 16 said the SEC’s lawsuit was "completely unfounded in law and fact" and that the agency didn’t warn the company before announcing the case. The Financial Times reported in April that Chief Executive Officer Lloyd Blankfein told investors the suit may have been politically motivated to help President Barack Obama’s administration convince Congress to approve legislation overhauling financial regulation. Those actions may have prompted the SEC to demand in the settlement that Goldman Sachs admit the mistake, Pitt said.
"If you want to dispute the government’s allegations, that’s fine," he said. "But if you want to malign or impugn the government’s motivations, that’s not fine. By extracting that agreement, the SEC has vindicated the fact that its lawsuit was filed for appropriate reasons." Goldman Sachs spokesman Michael DuVally declined to comment on why the firm admitted to a mistake. On a call with Wall Street analysts yesterday, David Viniar, the chief financial officer, was asked what impact the SEC settlement will have on any lawsuits against the company. "We don’t think it’s going to have any material impact," Viniar said. "We think there’s nothing new in the settlement."
The SEC is examining other firms and a range of structured products that fueled losses during the financial crisis, Enforcement Director Robert Khuzami said when announcing the settlement. SEC spokesman John Heine declined to comment on whether any future settlements would include demands that companies admit mistakes.
Goldman Sachs’s risk of being sued in private litigation may be limited, because the SEC complaint only listed two investors who lost money on the Abacus transaction. Royal Bank of Scotland Group Plc, which purchased a company that lost about $841 million on the mortgage security, hasn’t ruled out filing a lawsuit, a person with knowledge of the matter said July 16. The bank will receive $100 million as part of the SEC settlement. IKB Deutsche Industriebank AG, which lost about $150 million on the Abacus deal, will recoup that amount from Goldman Sachs. KfW Group, Germany’s development bank that bailed out IKB, has said it is reviewing the SEC accord.
The regulatory settlement also requires Goldman Sachs to reform its business practices. Those changes, along with new regulations being considered by the SEC, may make it harder for all Wall Street firms to sell opaque financial products to banks, pension funds and governments. When Goldman Sachs puts together a security tied to mortgages, the product must be reviewed and approved by a bigger group of corporate managers. The executives will be responsible for ensuring that marketing materials don’t include omissions or misstatements. Goldman Sachs also has to bolster compliance training for employees who sell the securities.
Khuzami said he hopes other firms adopt the "best practices." If they do, it will create obstacles to getting some securitizations done quickly, said Cliff Rossi, a managing director at the University of Maryland’s Center for Financial Policy in College Park. "The more pairs of eyes you have that have to review and sign off ahead of a deal, the more it slows things down," said Rossi, a former senior risk officer at Countrywide Financial Corp., Washington Mutual Inc. and Citigroup Inc. It’s a moot point for now, because there hasn’t been much demand for mortgage securities since the U.S. housing market collapsed in 2007.
Firms sold about $24 billion of these assets in the first half of 2010, and almost all were repackagings of existing bonds, according to newsletter Asset-Backed Alert. That’s down from a record of about $1.2 trillion in both 2005 and 2006. The instrument involved in the Abacus deal was a collateralized debt obligation. CDOs are pools of assets such as mortgage bonds packed into new securities. Wall Street firms sell most CDOs through so-called private placements, offerings that aren’t subject to SEC disclosure requirements because only clients with more than $100 million of invested assets can buy the securities.
The SEC in April said it’s considering requiring issuers of private offerings to provide disclosures equal to those available in public sales, if investors request the information. SEC Chairman Mary Schapiro said the proposal reflects a reconsideration of the regulator’s long-standing assumption that sophisticated investors like pension funds and endowments don’t need the same protections as individuals. The private market would be "virtually shut down" if the SEC approves the proposal, because of increased compliance costs said Edward Gainor, a law partner at Bingham McCutchen LLP in Washington.
S.E.C. Pursuing More Cases Tied to Financial Crisis
by Edward Wyatt - New York Times
Days after the Securities and Exchange Commission secured a $550 million settlement from Goldman Sachs, the agency’s chairwoman said on Tuesday that the commission was pursuing several other investigations related to the 2008 financial crisis. The chairwoman, Mary L. Schapiro, told reporters after a Congressional hearing that the S.E.C. had "a number of cases coming out of the financial crisis related to C.D.O.’s and other products" and involving Wall Street firms, banks and other financial institutions.
C.D.O.’s, or collateralized debt obligations, were the financial products at the center of the Goldman Sachs charges, which alleged that the bank misled investors in a subprime mortgage product as the housing market began to collapse. Goldman settled the S.E.C. complaint without admitting or denying the charges. Ms. Schapiro’s comments are the most direct signal yet that the S.E.C. is continuing to press for accountability and restitution for the upheaval in financial and housing markets in 2007 and 2008, which led to the sweeping regulatory bill that President Obama is scheduled to sign on Wednesday.
Officials at the Justice Department and other members of the Financial Fraud Enforcement Task Force, including the S.E.C., have said they are continuing to share information and to pursue other investigations into financial sector firms with questionable practices that came to light during the financial crisis. The S.E.C. has drawn particular criticism from Congress, investor groups and other quarters for a lack of prominent enforcement cases against firms that played a major role in the financial crisis, which cost individual and institutional investors billions of dollars in losses.
Ms. Schapiro defended the commission’s record on Tuesday, telling members of a House Financial Services subcommittee that the agency’s enforcement division had been restructured and reinvigorated since she took over in January 2009. Responding to questions from reporters after the hearing, Ms. Schapiro said the agency was looking beyond Goldman Sachs and that investors had "not necessarily" seen the bulk of cases that might stem from the financial crisis. "We have investigations in the pipeline across products, across institutions coming out of the financial crisis," she said. "We’ve brought a number of them. Nobody ever wants to pay attention to the ones we’ve already brought. But we’ve brought quite a few already coming out of the crisis over the last year and a half."
In recent months, she told the committee, the S.E.C. has brought cases claiming accounting and disclosure violations at subprime lenders, misrepresentation of complex mortgage securities as safe investments appropriate for retail investors and misleading statements to investors about a fund’s exposure to subprime investments. For example, last month the commission charged ICP Asset Management of New York with fraud and conflicts of interest related to its management of multiple C.D.O.’s and an affiliated hedge fund in 2007. The company denied the charges.
In February, the commission settled a case with State Street Bank and Trust of Boston in which the S.E.C. charged that the company misled investors about their exposure to subprime investments while selectively disclosing more complete information to certain favored clients. State Street paid $313 million to settle the case. But the S.E.C. has not brought any cases against credit rating agencies related to the financial crisis, although those companies provided investment-grade ratings to many packaged mortgage investments that quickly turned out to be based on questionable loans to unqualified borrowers.
S.E.C. officials say they are continuing to investigate the credit rating agencies. But the Credit Rating Agency Reform Act of 2006 prohibits the S.E.C. from regulating the substance, criteria or methodologies used in credit rating models, making those inquiries more difficult. On Tuesday, some members of Congress expressed eagerness for the S.E.C. to follow up its case against Goldman Sachs with other actions.
"I, for one, am hopeful that this legal action will be the first, and not the last, brought by the commission against the hucksters of Wall Street who spun toxic mortgages into golden financial opportunities by hiding information or defrauding investors by other means," said Representative Paul E. Kanjorski, Democrat of Pennsylvania, who is chairman of the capital markets subcommittee.
The S.E.C. has only civil authority; the Goldman case was referred to the Justice Department for possible criminal proceedings. While Justice officials have said that a criminal investigation is continuing, they have also noted the difficulty of bringing such cases and have sought to dampen any expectations that charges could be imminent. That difficulty was exhibited last year, when the Justice Department charged two Bear Stearns hedge fund managers with lying to investors about the precarious state of investments they oversaw. A federal court jury in Brooklyn found the two managers not guilty, saying essentially that while the managers made bad investments, that itself was not a crime.
The setback has not stopped further prosecutions, however. Last month, the former chairman of a lending company, the Taylor, Bean & Whitaker Mortgage Corporation of Florida, was indicted for his role in what the government said was a $1.9 billion fraud scheme that led to the collapse of Colonial Bank of Alabama, one of the 50 largest banks in the United States. The former chairman, Lee B. Farkas, pleaded not guilty.
Goldman Profit Magic Goes Missing
by Susanne Craig and Scott Patterson - Wall Street Journal
When the financial markets are topsy-turvy, Goldman Sachs Group Inc. has a knack for finding a way to profit from the turbulence. That didn't happen in the second quarter. Goldman reported an 82% profit tumble, hurt by a surprisingly steep decline in revenue that included a wrong-way bet on the stock market's volatility. The New York company didn't disclose the size of the loss, which occurred in its equity-derivatives business and is an unusually large blunder given Goldman's reputation for prudent risk management.
In contrast, the huge hit to Goldman's bottom line from the $550 million settlement announced last week with the Securities and Exchange Commission plus $600 million set aside to cover the new U.K. bonus tax caused barely a ripple among analysts and investors. Net income fell to $613 million, or 78 cents a share, down from $3.44 billion, or $5.59 a share, in last year's second quarter, when Goldman earned more than it did in all of 2008. Net revenue shrank 36% to $8.84 billion from the year-earlier $13.76 billion. The latest quarter's net revenue and earnings were the smallest since 2008's fourth quarter, while net income was the fourth-lowest since Goldman went public in 1999.
Like J.P. Morgan Chase & Co. and other financial firms that rely on trading revenue, Goldman was bruised in the second quarter by worries about economic growth, toughened financial regulation and Europe's sovereign-debt problems. Goldman Chief Financial Officer David Viniar said many trading clients "lacked conviction" and "sat on the sidelines." Goldman, led by Chief Executive Lloyd Blankfein, also reined in its own trading appetite, with the firm's value-at-risk declining to an average of $136 million in the second quarter from $161 million in the first quarter and $245 million in last year's second quarter. Value-at-risk is a yardstick of how much in losses could be suffered in one trading day.
But the firm made a costly decision not to completely hedge bets made by customers that the market's volatility would rise during the second quarter. "We were directionally wrong," Mr. Viniar said. Asked whether Goldman itself made a mistake in the firm's view of turbulence in the market, Mr. Viniar responded that Goldman "didn't hedge it fast enough." One managing director on the stock-derivatives desk that is responsible for the losses recently left Goldman, and other employees in the unit are considering leaving, according to people familiar with the situation. The departed managing director was a salesman. Goldman declined to comment.
As a result of the losses, "the most striking shortfall on the revenue line was equities trading, which registered the lowest quarterly figure at least back to 2003 in our model," said Barclays Capital analyst Roger Freeman. Analysts surveyed by Thomson Reuters had expected Goldman to report revenue of $8.94 billion. Net revenue in the firm's equities department, which includes the stock-derivatives desk, fell 62% to $1.21 billion from $3.18 billion in last year's second quarter. Fixed-income, currency and commodities-related net revenue, the biggest profit engine at Goldman, slumped 35% to $4.4 billion from the year-earlier $6.8 billion. Excluding the impact of the SEC settlement and U.K. bonus tax, Goldman said it earned $2.75 a share.
Goldman set aside $3.8 billion, or 43% of its net revenue in the latest quarter, to cover employee compensation and benefits. So far this year, Goldman has set aside $9.3 billion, or $272,581 per employee, in total compensation and benefits, down 18% from $11.36 billion, or $364,135 per employee, in the first half of 2009. The U.K. bonus tax imposes a non-deductible 50% tax on financial companies that issue discretionary bonuses of larger than £25,000, or about $40,000. Mr. Viniar reiterated that the SEC's civil-fraud lawsuit against Goldman, filed in April and settled last week, didn't cause a noticeable client exodus, adding that firm still ranks No. 1 in the high-profile business of advising companies on mergers and acquisitions.
But some analysts remain concerned that Goldman could face further accusations by the SEC. Last week, the SEC said as part of its settlement announcement that the $550 million deal "does not settle any other past, current or future SEC investigations against the firm." In a separate statement last week, Goldman said it believed that "the SEC staff also has completed a review of a number of other Goldman Sachs mortgage-related CDO transactions and does not anticipate recommending any claims against Goldman Sachs or any of its employees with respect to those transactions based on the materials it has reviewed." Mr. Viniar said Tuesday that the SEC reviewed Goldman's statement before it was released. A spokesman for the SEC declined to comment on Mr. Viniar's remarks.
The SEC is proceeding with civil-fraud charges against Fabrice Tourre, the Goldman trader accused by the SEC of being "principally responsible" for piecing together the mortgage-bond deal at the center of the suit. Mr. Tourre, who is on paid leave from Goldman, denied in a court filing late Monday misleading investors. Goldman is paying the legal costs of Mr. Tourre's defense. Mr. Viniar described the case as "a separate suit against him, not against us, so it's totally appropriate for him to have his own lawyer."
SEIU, Labor Directly Lobby Geithner On Elizabeth Warren's Behalf
by Sam Stein - Huffington Post
The labor community is going to lend its considerable political clout to the effort to get Elizabeth Warren confirmed as the first head of the newly-created Consumer Protection Agency, going directly to the White House official who may stand in her way.
On Tuesday, SEIU President Mary Kay Henry will "raise the point that Elizabeth Warren would be an excellent head of the newly created Consumer Protection Agency" in private talks with Treasury Secretary Timothy Geithner, according to a senior source with the union. The tete-a-tete adds an element of intrigue into the debate over who should head the new but important agency and could set up a now-familiar scenario in which the labor community finds itself butting heads with the White House's economic team.
Geithner has privately expressed skepticism with Warren's candidacy for the post -- despite the fact that she is considered the godmother of the very idea that consumers need a watchdog agency on their behalf. The Treasury Secretary is wary about the message that Warren's appointment would send to the financial community and would prefer to appoint Michael Barr, a senior Treasury Department official who was instrumental in crafting financial regulatory reform.
In public, the White House has insisted that it is open up to all candidacies, including Warren's. But Geithner's private musings have spurred an intense pushback.
In addition to Kay Henry's visit to Treasury, another major union, the AFL-CIO, has directly lobbied the White House on Warren's behalf, according to a source with the union federation. Meanwhile, the Progressive Change Campaign Committee, a liberal activist group, has colleted roughly 140,000 signatures in a petition drive urging the White House to nominate Warren for the new post.
Warren, it should be noted, could assume the post by executive appointment under the newly passed regulatory reform law. This would allow her to avoid a bitter confirmation fight in which she would need the support of 60 Senators in order to make it through the Senate.
UPDATE: AFL-CIO President Richard Trumka released the following statement on Tuesday morning on regulatory reform and Warren's candidacy:The AFL-CIO applauds the passage of the Wall Street Accountability Act and looks forward to the creation of the new Consumer Financial Protection Bureau - which has the potential to be a powerful and independent voice for consumers.
In our view, there is only one candidate who is uniquely qualified and equipped to head this new agency. Harvard Law School Professor Elizabeth Warren originated the idea of the Consumer Financial Protection Bureau, and has proven as Chair of the Congressional Oversight Panel to be a strong and fearless advocate for the American public. We therefore strongly urge President Obama to appoint Professor Warren as Director of the new consumer protection bureau.
Professor Warren's appointment would make clear that under President Obama's leadership, there truly will be accountability for Wall Street and fair treatment for the American public in the financial marketplace.
FURTHER UPDATE: The SEIU has now put up a blog post on its website touting Warren for the post.Warren has spent her entire career fighting for the interests of working families and supporting policies to help rebuild our middle class. In fact, Warren even came up with the concept of a new consumer watchdog. As head of the new Consumer Financial Protection Bureau, she'll work each and every day to stand up to Wall Street and demand commonsense financial products that will protect us from the next economic meltdown.
Elizabeth Warren Could Head Consumer Financial Protection Bureau Without Senate Confirmation
by Shahien Nasiripour - Huffington Post
Elizabeth Warren could lead the new Consumer Financial Protection Bureau without ever having to face a Senate confirmation hearing. The Harvard Law professor and bailout watchdog, beloved by the left and reviled by big banks, is one of three candidates the White House identified Friday as potential picks to lead the new consumer agency. Created as part of the financial reform bill President Barack Obama is expected to sign into law on Wednesday, the agency is supposed to protect borrowers from predatory lenders and centralize the federal government's role when it comes to extending credit to consumers.
Warren conceived of the agency in 2007 and since last year has served as the public face of the campaign to enact it into law. But some have speculated Warren may face an uphill battle to become its inaugural chief. Lenders fear her -- particularly given her strong advocacy on behalf of the debt-strapped middle class -- and are furiously fighting her potential nomination as she's viewed as the most consumer-friendly of the candidates. Their friends in the Senate may take up their cause.
Proponents and critics agree that the first director will have a lasting impact on the agency, from the hiring of staff to the general attitude it takes towards consumer protection. Some are expected to prepare a Supreme Court-style campaign when Obama names his nominee. During a radio interview Monday, Senate Banking Committee Chairman Christopher Dodd said there's a "serious question" over whether she, as Obama's nominee, could be confirmed by the Senate. "We are confident she is confirmable," White House spokeswoman Jennifer Psaki said.
The administration, though, could bypass the Senate entirely -- without engendering the ill-will that would result from a recess appointment. According to the bill's language, the Treasury Secretary has sole authority to build the new agency before it's ultimately transferred to the Federal Reserve. That includes anointing a person to head the effort on his behalf, and under his authority. The interim head would serve until the President's nominee is confirmed by the Senate. That person could be Elizabeth Warren.
And the legislation doesn't appear to contain a deadline for a Presidential nomination, experts say, which means Warren could start the agency from scratch, put her people in, begin cracking down on predatory and abusive lenders, and initiate a culture that would put consumers' interests above those of the nation's most powerful financial institutions. In short, she could set a tone the agency will follow for the next several years without the administration needing to fight a potentially drawn-out confirmation battle that could stall Obama's pro-consumer agenda.
"The statute gives the Treasury Secretary the obligation to get it done, but doesn't tell him how to get it done," Gail Hillebrand, a senior attorney at Consumers Union and manager of the group's financial services campaign, said about the Secretary's role in creating the new agency. Picking an interim head is one of the authorities Congress granted him in the legislation. Whomever Geithner hires would be serving that role on his behalf, and would ultimately be his responsibility. So Geithner could, presumably, hire Warren on a contract basis to perform that role, Hillebrand said.
Michael Barr, the Treasury's assistant secretary for financial institutions, and Eugene Kimmelman, a top Justice Department official who worked for various consumer groups prior to government service, are the other candidates for the position, White House officials said Friday. Geithner is said to prefer Barr, a key lieutenant and a noted consumer advocate, for the role. Geithner opposes Warren's nomination, according to a source familiar with Geithner's views, though the Treasury Secretary, through Barr and a department spokesman, said Friday that Warren is "well qualified" for the position.
Though Hillebrand said she couldn't immediately pinpoint a deadline in the legislation mandating a Presidential nominee, she added that there must be some kind of deadline that she wasn't aware of. It wasn't immediately clear, though. Geithner's pick would be able to begin protecting taxpayers and consumers "immediately," Hillebrand said. And the pick could serve for months, if not longer. That's what the legislation was probably designed to accomplish, the consumer advocate noted. Whenever a new federal agency is created it makes sense to pick someone in the interim "to get things going. Clearly, that would be authorized here," she said. "Consumers have waiting a long time," Hillebrand said. "The sooner we can get it off the ground the better."
Americans for Financial Reform, a coalition of more than 250 groups organized to fight for strong financial reform, endorsed Warren on Monday to head the new agency. Rep. Carolyn Maloney, a New York Democrat, and Senator Tom Harkin, a Democrat from Iowa, are both asking colleagues to sign letters urging Obama to nominate Warren for the post. As of 7 p.m. Washington time on Tuesday, 39 members of the House had signed on to Maloney's letter, including House Financial Services Committee Chairman Barney Frank, Maloney's spokesman told HuffPost. Sen. Bernie Sanders, an independent from Vermont aligned with Senate Democrats, wrote Obama on Monday asking him to nominate Warren. "No one in our nation could do a better job," Sanders wrote.
Heather Booth, AFR's director, said proponents of reform should fight for "the strongest, most qualified" candidate to head the consumer agency. AFR endorsed Warren. "If there are people representing the interests of the biggest financial institutions, they can vote against" the candidate, Booth said. "This is the time to vote whether you're for Main Street or for Wall Street." Hillebrand added that regardless of when Obama picks the nominee there's going to be an "ideological fight."
So rather than face that fight now -- and potentially stall an agenda -- one consumer advocate suggested there's nothing stopping the administration from installing the candidate most likely to fight back against the big banks on behalf of consumers. On Friday, White House senior adviser David Axelrod told reporters that regardless of whether Warren is picked to officially head the agency, "one thing I know for certain is however we move forward she's going to be a strong voice in helping shape this and make it the most effective voice for consumers that it possibly can be."
Geithner picking her as the interim choice could be what Axelrod was referring to. Warren declined to comment for this article. It is unclear whether she'd be interested in serving in such an arrangement. A Treasury spokesman said the department is first looking forward to Obama's signing of the bill on Wednesday.
Bond Sale? Don't Quote Us, Request Credit Ratings Agencies
by Anusha Shrivastava - Wall Street Journal
The nation's three dominant credit-ratings providers have made an urgent new request of their clients: Please don't use our credit ratings. The odd plea is emerging as the first consequence of the financial overhaul that is to be signed into law by President Obama on Wednesday. And it already is creating havoc in the bond markets, parts of which are shutting down in response to the request.
Standard & Poor's, Moody's Investors Service and Fitch Ratings are all refusing to allow their ratings to be used in documentation for new bond sales, each said in statements in recent days. Each says it fears being exposed to new legal liability created by the landmark Dodd-Frank financial reform law.
The new law will make ratings firms liable for the quality of their ratings decisions, effective immediately. The companies say that, until they get a better understanding of their legal exposure, they are refusing to let bond issuers use their ratings. That is important because some bonds, notably those that are made up of consumer loans, are required by law to include ratings in their official documentation. That means new bond sales in the $1.4 trillion market for mortgages, autos, student loans and credit cards could effectively shut down.
There have been no new asset-backed bonds put on sale this week, in stark contrast to last week, when $3 billion of issues were sold. Market participants say the new law is partly behind the slowdown. "We are at a standstill right now," said Bingham McCutchen partner Ed Gainor, who specializes in asset-backed securities. Several companies are shelving their bond offerings "indefinitely," according to Tom Deutsch, executive director of the American Securitization Forum, which represents the market for bonds backed by assets such as auto loans and credit cards. He said he knew of three offerings scheduled for coming weeks that are now on hold.
The change caught the ratings agencies by surprise. The original Senate version of the bill didn't include the provision. It was only on June 30, when the Dodd-Frank bill was passed, that the exemption was removed. The Senate passed the amended version on July 15. The offices of Sen. Christopher Dodd (D-Conn.) and Rep. Barney Frank (D-Mass.) didn't immediately respond to a request for comment. Rating firms have warned that sections of the legislation concerning ratings' firms legal liability could cause them to pull back from certain parts of the market.
In an April 21 conference call, Moody's Chief Executive Raymond McDaniel told investors that "we remain concerned that the bill's liability provisions would lead to unintended consequences that could negatively impact the credit markets." If greater liability provisions were passed, he continued, "we would implement appropriate changes." He added that Moody's, a unit of Moody's Corp., would rethink whether it still made sense in a new regulatory environment to give ratings "for as many small and perhaps marginal issuers as possible."
The confusion comes as investors, bankers and ratings companies across Wall Street seek to digest the intricacies of the new law, the most sweeping since the 1930s. The overhaul touches on virtually every part of the financial-services world, part of an effort by lawmakers to head off another financial crisis. Ratings providers became a lightning rod for criticism after the financial crisis. Their overly rosy assessments of many bonds, particularly complex securities and bonds backed by subprime mortgages, were blamed for helping fuel the meltdown of the credit markets. In response, the Dodd-Frank bill revamped how the government treated credit-ratings firms, which receive a special government designation that allows them certain privileges and market access.
Once the bill is signed into law, advice by the services will be considered "expert" if used in formal documents filed with the Securities and Exchange Commission. That definition would make them legally liable for their work, meaning that it will be easier to sue an firm if a bond doesn't perform up to the stated rating. That is a change from the current law, which considers ratings merely an opinion, protected like any other media such as a newspaper.
Prior to the Dodd-Frank bill, issuers were allowed to include the description of the ratings in the offering documents without the consent of the rating firms. Now, they will have to get written permission. And the rating providers are concerned that giving such consent exposes them to liability they haven't been exposed to in the past. Unlike many parts of the larger financial-overhaul bill, these changes go into effect as soon as it is signed into law. The speed of the move has spooked the three firms. All issued statements in recent days saying they will continue to issue bond ratings. But they said they won't allow those ratings to be used in formal documents accompanying bond sales, known as prospectuses and registration statements.
One solution to the logjam is for sellers of bonds to offer their deals privately. That means they would offer ratings that can be used in private transactions but not in deals registered with the SEC and sold to the general public. The private market is much smaller and more expensive than the public one. On Friday, S&P, a unit of McGraw-Hill Cos., issued a release saying it would "explore mechanisms outside of the registration statement to allow ratings to be disseminated to the debt markets."
Unemployment Extension Bill Clears Hurdle, Standoff Likely Over Until November
by Arthur Delaney - Huffington Post
The Senate voted 60-40 on Tuesday to move forward with reauthorizing unemployment benefits for the long-term jobless, 2.5 million of whom have missed checks since the end of May as Republicans and conservative Democrats filibustered several bills to renew the aid. After a final Senate vote, the bill goes to the House, which will vote on Wednesday.
"It shouldn't take a supermajority to help families afford the bare necessities while unemployment is rising," said Senate Majority Leader Harry Reid (D-Nev.) after the vote. "It shouldn't take the slimmest of margins to do what is right." Defeating the filibuster clears an easy path toward the president's desk this week. People who missed checks will be paid retroactively; people who exhausted all weeks of benefits available before the lapse will not get anything.
The great debate pitting deficit reduction against jobless aid is over -- until November, when it is certain to return. White House Press Secretary Robert Gibbs said Monday that the president will push for an additional extension of benefits when the current one expires shortly after the midterm congressional elections. "I think it is fair and safe to assume that we are not going to wake up and find ourselves at the end of November at a rate of employment one would not consider to be an emergency," Gibbs said, in one of the most affirmative statements from Democrats about their plans for the next lapse in benefits.
Historically, Congress has never allowed federally-funded extended benefits to lapse when the national unemployment rate has been above 7.2 percent. The current rate is 9.5 percent, and few projections show it coming down any time soon. Republicans in the Senate, along with Nebraska Democrat Ben Nelson, had blocked the bill because its $33 billion cost was not "paid for." For 49 days after the benefits lapsed, Republicans and Nelson complained that deficit spending would worsen the economy, and many wondered whether extended benefits don't actually make people too lazy to look for work -- though the official line from Republicans has been that the cost of the benefits needed to be offset by taking funds from the 2009 stimulus bill.
"Republicans support extending benefits to the unemployed," said Mitch McConnell (R-Ky.), the Republican leader in the Senate. "As the president himself said yesterday, we've repeatedly voted for similar bills in the past. And we are ready to support one now. What we do not support -- and we make no apologies for -- is borrowing tens of billions of dollars to pass this bill at a time when the national debt is spinning completely out of control." Maine Republicans Olympia Snowe and Susan Collins joined Democrats in breaking the filibuster; Ben Nelson stuck with the GOP. Democrats' previous attempt failed by one vote after the death of Sen. Robert Byrd (D-W.Va.) in June. His replacement, Carte Goodwin, gave the Democrats the 60 votes they needed.
The lapse caused plenty of anxiety and hardship for people who've been out of work for more than six months. "What a shame that it had to drag on so long, especially in light of the fact that it was only a matter of time before it was passed," said Judy Conti, a lobbyist with the National Employment Law Project. "Even retroactive checks won't make up for the people who have had their cars repossessed in the last month, who have been evicted from their apartments or houses, or who have faced other atrocities because of this unconscionable delay."
The View From Bernanke's Perch at the Fed
by David Wessel - Wall Street Journal
Until recently, attacking Federal Reserve Chairman Ben Bernanke for being too passive sounded out of touch with reality. Indeed, he has been assailed for doing too much to bail out Wall Street and for risking the Fed's independence and inflation-fighting credibility by buying $1.5 trillion of mortgages and U.S. government bonds.
Yet the question lurking when Mr. Bernanke testifies in Congress this week is why the central bank isn't doing more now to rescue an economy that is losing momentum. After all, the Fed's forecast is for inflation below its informal target and persistently high unemployment for the next couple of years.
Here, more bluntly than Mr. Bernanke will put it if Congress ever gets around to asking, is what's going on. The distressing economic outlook has deteriorated since the Fed's June 22-23 meeting. Mr. Bernanke would cut short-term interest rates if he could. But he can't; rates are already near zero. So the question is whether to pursue more-unconventional monetary policy. The Fed, perhaps prematurely, ended its purchases of mortgages earlier this year. As the minutes of the June meeting note, Fed officials are at least talking about what would justify reopening the spigot.
There are a lot of little things the Fed could do to signal concern about the economy—and Mr. Bernanke may enumerate them if pressed. But the most likely to matter would be to buy more mortgages and Treasurys to push down long-term rates. For now, Mr. Bernanke doesn't believe potential benefits of such a move outweigh potential costs. But he and his allies on the Fed's divided policy committee aren't saying never. Whether or not he explicitly says so, the Fed will consider buying more securities if the economy gets worse or credit markets show signs of severe distress, despite the eagerness of some Fed officials to move toward "the exit strategy."
Why wait? Put yourself in Mr. Bernanke's chair. When the Fed began buying mortgages, the gap between yields on mortgages and Treasurys was wide; now it isn't. Mortgage rates are very low and the housing sector is still moribund; it isn't clear pushing mortgage rates down another one-quarter percentage point would do much. The Fed could buy more Treasurys, trying to push yields on 10-year Treasurys below the already low 3%. But that could backfire. With all the deficit angst around, a Fed move to buy Treasurys could provoke cries of "they're monetizing the debt" and push up long-term rates rather than lowering them.
As scary as this sounds, the Fed can't be sure of the net effect of buying more assets. It might not make things better. It would be, in short, a Hail Mary pass. And Mr. Bernanke isn't ready—yet—to throw it.
Mr. Bernanke's former Princeton University colleague, Nobel laureate Paul Krugman, has become the loudest critic of Mr. Bernanke's inaction, calling the Fed "feckless" (lacking in vitality, unthinking, irresponsible) in his New York Times column.
In a prescient 1998 paper about Japan, Mr. Krugman warned that other countries might similarly confront the feared "liquidity trap," the circumstance at which the central bank has cut interest rates to zero and the economy remains very weak. His advice then: "Monetary policy will be effective…if the central bank can credibly promise to be irresponsible"—by promising to create inflation in the future. The textbook point: Interest rates that matter are the inflation-adjusted ones. In recessions, the Fed effectively pushes inflation-adjusted rates below zero. But with nominal interest rates at zero, the only way to get inflation-adjusted rates lower is to get everyone believing that inflation will go up.
The practical point: This is easier to advise than to do safely. It would, at the very least, be hard to explain to a public already suspicious of the Fed. And it, too, could backfire. Manipulating inflation expectations is hard to calibrate. And the move would mean higher nominal (though lower inflation-adjusted) long-term interest rates. And outside of economic textbooks, higher nominal rates can hurt, pinching cash-strapped households for instance. It's risky. Mr. Bernanke, in a widely re-read 2002 speech, argued that the Fed can create inflation and can thwart deflation. Mr. Krugman thinks deflation is around the corner; Mr. Bernanke isn't convinced.
If the Fed is truly out of good choices, then talk turns to fiscal policy. Both Mr. Bernanke and his deputy-designate, Janet Yellen of the Federal Reserve Bank of San Francisco, have been cautiously giving Congress advice on that. "If simultaneously Congress were to put in place meaningful measures that would phase in over time to address medium- and longer-term deficit issues…that would create greater scope in the shorter term for Congress to also contemplate…actions to address short-term weakness in the economy," Ms. Yellen said at a hearing last week, echoing similar advice from Mr. Bernanke.
In plain English, the Fed would welcome more fiscal stimulus if accompanied by a credible, specific commitment to reduce the deficit later. But the chances of Congress and the president executing that two-step maneuver are close to nil. Which means, if things get worse, Mr. Bernanke may yet resort to the Hail Mary.
Double dip in the Baltic
by Ambrose Evans-Pritchard - Telegraph
The raging dispute over the Baltic Dry Index is starting to feel like the Jansenists debate with the Ultramontanists, with the Big Media playing the enforcement role of Pope Innocent X against heretical bloggers such as Zero Hedge. Is the latest collapse in the BDI a leading indicator of a wilting souffle in China/US/world, or is it just the lagging effect of new ships flooding the market? Or both at once.
The facts are that the BDI index of freight rates for bulk goods such as iron ore, coal, and soybeans, has fallen from 4,200 to 1,720 since the end of May. The Capesize index (ships too big for the Suez Canal, and essentially a proxy for iron ore) has dropped even more sharply from 5,520 to 1,676. These indexes are highly volatile. They gave a good warning signal before the onset of the Great Recession, but they also gave a false alert when they plunged in the early summer of 2005. William Lyth from the Baltic Exchange says you need to keep an eye on two twists that are unrelated to the health of the global economy.
- “There are too many ships. People have over-ordered and it is starting to bite. There are 235 new Capesize vessels hitting the market this year,” he said.
- More murky is the game being played between China and the big Iron ore companies, Vale, BHP, and Rio. China has stockpiled a near record 70 million of iron ore. If it using this reserve as bargaining tool in its battle with suppliers, that would explain part of the Capesize crash (and Capesize make up a quarter of the BDI index)
That said, I am broadly on the side of the heretics (surprise, surprise). It makes little sense arguing about the BDI without taking into account the blizzard of dire data from the US over recent weeks, and the turn in the OECD leading indicators for China, India, Brazil, France, Italy, the UK, and Canada – ie, the world economy minus Germany (which is a special case with a rigged currency).
China’s campaign of lending curbs to cool the property sector are starting to bite (though my wife and son currently in Hangzhou tell me that there is absolutely no sign of a construction halt in that city). There was sharp slowdown in Chinese industrial output in tail-end of Q2. Baoshan Iron and Steel has cut steel prices for the last two months, and China Steel Corp (in Taiwan) followed this week. Lloyd’s List has reported warnings that some Chinese steel makers may default on contracts with shippers.
When the US Federal Reserve reveals suddenly that it may abandon its exit strategy and resort instead to another blitz of stimulus – ie, QE2 – it is surely worth asking why. Leaving aside the collapse in the ECRI leading indicator last week to -9.8 (a level that has always preceded recession in the post-war era, but may of course be wrong this time because we are in a zero-rate, mega-stimulus, fin de regime, total upheaval that makes any comparison with past cycles meaningless), there are some hard facts.
New homes sales collapsed in May to a record low of 300,000 with the expiry tax credits for first-time buyers. US retail sales fell 1.1pc in May and 0.5pc in June. Manufacturing output fell 0.4pc June. The Philly Index for new manufacturing orders fell to -4.3 in July. Confidence indicators have been ghastly across the board. The American Trucking Association said tonnage fell 0.6pc in May (the most recent available). “There is no way that freight can increase every month, and we should expect periodic decreases,” said chief economist Bob Castello. I await his comments on the June data.
The American Association of Railroads said car loadings fell 1.1pc in May, and a further 1.3pc in June (month-on-month, seasonally adjusted). “They have now declined for two consecutive months. The declines in railroad loadings over the past couple of months have not been huge, and they certainly don’t prove the wheels are coming off the economy’s bus,” said the AAR. True, they don’t prove anything. They are evidence of something.
Total rail car loadings have recovered from the depths of the Great Recession but are still down 10.2pc from June 2008. “We still have a long way to go to see rail traffic levels associated with a full recovery,” said AAR’s vice president John Gray. As I reported last week, outbound traffic from the Port of Long Beach fell from 139,000 containers in May to 116,000 in June. Shipments from the Port of Los Angeles fell from 161,000 to 155,000. Imports did much better, perhaps reflecting the previous rally in the dollar. That is a mixed blessing.
Air freight tells another story. IATA said blobal freight traffic was up 34pc in May from a year earlier. “It is absolutely booming,” Lufthansa’s chief executive officer, Stephan Gemkow. But air freight tends to be a current indicator, not a leading indicator. It covers mostly finished goods, in a high-value added niche. It accounts for 1pc of global tonnage shipped, but 33pc of total value.
Yes, we have seen a large rise in most indicators from the depths of despair in early 2009. That does not tell us very much. Massive stimulus launched a V-shaped recovery despite the debt burden hanging over the economy. Perma-bears have always argued that this was built on unstable foundations, and would tip over as government stimulus fades. We will find out over the next three or four months whether they are right.
Double dip fears in Britain as bank loans dry up
by Larry Elliott and Jill Treanor - Guardian
George Osborne and Vince Cable will spell out next week the dangers of a double-dip recession caused by a drying up of bank lending to Britain's hard-pressed small and medium-sized businesses. A green paper, to be rushed out by the chancellor and business secretary before next week's parliamentary recess, will acknowledge the scale of the lending rationing crisis, which could "abort" the fragile recovery.
As the Bank of England (BoE) published data showing yet another month when more loans had been repaid than had been granted, Cable admitted the level of anxiety in the government about the flow of funds to smaller companies. He said: "The green paper will acknowledge the scale of the problem and how the recovery could be aborted if we don't get on top of this. "There is a fundamental policy conflict between efforts to make the banks safer and our wish to get them lending more freely to promote growth," Cable said.
He has been presented with research from the banks – which have given the work by PricewaterhouseCoopers the name "Project Oak" – showing that tougher capital rules and the end of emergency liquidity injections from the BoE could drain the banking system by £1 trillion in the coming years. Cable believes there is a "very frustrating standoff" between the banks and small businesses: banks argue there is no demand, while businesses say they are not applying for loans because they expect to be rejected or the cost is too high.
"We have to acknowledge there is an issue," said Cable. Even so, he does not appear to be ready to alter the current lending targets for Royal Bank of Scotland and Lloyds Banking Group, which run until next March. Since the 2008 banking crisis, lending figures from the banks compiled by the BoE have been positive in only three months. The Liberal Democrats calculated that £46bn of loans had been withdrawn in the past year alone.
Howard Archer, economist at IHS Global Insight, agreed with Cable that the BoE data showed "several worrying traits". Archer said: "The survey very much maintains concern that tight credit conditions could hold back the recovery. This is even allowing for the fact that ongoing muted bank lending to companies is being influenced significantly by low demand for credit in addition to restricted supply. "Lack of access to credit for smaller businesses is still a serious problem despite some reports that it has risen slightly in recent months," said Archer.
The low level of activity in the mortgage market – where June's 48,000 approvals were the lowest since May 2009 – also prompted Archer to forecast that house prices would fall by 3% to 5% over the second half of the year. Banks are determined to press their case that the problem is a lack of demand of credit. Stephen Hester, chief executive of RBS, has argued that 74p of every £1 lent to businesses before the banking crisis was to the property sector as a way to try to explain the downturn in lending.
The British Bankers' Association also argues that the behaviour of customers, whether businesses or households, is entirely logical. A BBA spokesman said: "The Bank of England's figures concur with our own: they show that bank customers are responding to the downturn by using their deposits to pay off loans. This is exactly the pattern we would expect to see in downturns. In the meantime, bank lending to individuals and small businesses is governed principally by demand, which reduced during the recession but which now shows signs of stabilising."
Lord Oakeshott, Liberal Democrat Treasury spokesman, stressed the coalition's commitment to tackling the problem. "The banks inflicted a savage £46bn squeeze on British business in Labour's last year in office … getting them lending again to boost growth and jobs is a top priority for the coalition," he said. Even as the issue of getting credit flowing around the system was being discussed by the government, anxiety over the outcome of Europe-wide stress tests on 91 crucial banks and financial firms was driving the rate at which banks lend to each higher to their highest levels in more than year. The rate to borrow in euros measured by the London Interbank Offered Rate hit levels last seen in August of 0.81125.
The results of the stress tests are to be published after the markets close on Friday, giving any banks that need to raise extra capital the weekend to do so. The four banks tested by the Financial Services Authority – Barclays, RBS, Lloyds and HSBC – are not thought to need more cash to withstand any deterioration in the European economy or the onset of a sovereign debt crisis.
British banks face £390 billion 'funding gap'
by Harry Wilson - Telegraph
British banks face a funding crunch next year as they attempt to refinance debt amounting to double the amount they raised on average during the years of the credit boom. Banks must raise about £390bn in new debt in 2011, or more than £30bn every month just to replace their existing funding as they are hit by a combination of maturing bonds and the closure of major Government-guaranteed financing schemes. Nomura analysts, in a presentation yesterday, pointed to last month's Bank of England Financial Stability Report (FSR) as they warned of the funding crunch facing the UK's major banks.
While the banks of other major European countries, such as France, Germany and Italy, face their own funding issues next year, none has to refinance anything like the same amount as the UK banks, which must replace debt worth just over 200pc of the average raised in the years 2005 to 2007. "UK banks face significant refinancing requirements over the next few years, as funds raised prior to the credit crisis mature," said Robert Law, co-head of banking research at Nomura.
"Lloyds and RBS are undertaking substantial medium-term restructuring of their balance sheets. This target includes targets to reduce assets in nominal terms over five years. "In our view, this restructuring is partly aimed at managing their refinancing requirements, as well as reducing wholesale funding an particularly the proportion of short-term financing within that."
Of the £390bn that must be raised next year, about £200bn will be in the form of maturing bonds and residential-backed mortgage securities that will require refinancing. The remaining £190bn consists of Government funding programmes; the Credit Guarantee Scheme; and the Special Liquidity Scheme, which the Bank of England insists will be phased out by the end of 2012.
Mr Laws at Nomura is sceptical that Britain's banks will be able to wean themselves off Government support so quickly, but concedes that the authorities cannot let up the pressure on UK financial institutions to become fully-privately funded. In the FSR the Bank of England admitted that replacing all this funding would be a "substantial challenge", and put the total figure on the amount that UK banks need to refinance by the end of 2012 at between £750bn and £800bn, working out an average monthly fundraising rate for the next two and a half years of more than £25bn. This is double the fund raising rate for the years between 2001 and 2007 of £12bn.
Raising this money will come against a much tougher backdrop for the banking industry, which though improved from the months immediately following the financial crisis of late 2008, is still far from the easy money years of the credit boom. In particular banks and investors will be looking for this Friday's publication by the European authorities of the results of a series of stress tests on the region's banks. The stress tests are intended to counter market scepticism surrounding the financial state of many of Europe's banks, ranging from the major financial institutions of Spain to Germany's small landesbanks.
Since the beginning of July, no southern European bank has been able to access the international capital markets, while bond issues even from major northern European banks have not proved easy. Mr Laws and the Nomura banks research team are sceptical that the publication of the stress tests will soothe investor fears, and warn that any lack of transparency will be taken badly by the market.
UK deficit fears reappear as public debt hits £927 billion
by Philip Aldrick - Telegraph
Plans to cut Britain's mountainous national debt have been given fresh urgency by new figures showing that the state of the public finances is even worse than feared. Public borrowing in June hit £14.5bn, well above economist expectations of £13bn despite being £200m less than last year, and was revised upward from £16bn to £17.1bn in May, according to the Office for National Statistics. If the trend continues, the Government may miss its target for the budget deficit, raising fresh questions about the country's ability to control its £927bn debt burden.
George Osborne, who announced £113bn of spending cuts and tax rises in the Budget to shake off market concerns and preserve the UK's AAA credit rating, said: "The public finance numbers today remind us why we need to get on top of the budget deficit." Net debt rose to 63.9pc of GDP at the end of the second quarter, the highest since records began in March 1993. The pound slid in early trading following publication of the figures before rallying to close 0.2pc stronger against the dollar at $1.5242.
Jonathan Loynes, of Capital Economics, said: "June's borrowing total left a cumulative deficit in the first three months of the year of £40.3bn. Extrapolating this forward points to a full-year deficit of about £152bn, about £3bn above the Budget forecast." Concerns about the public finances, described by HSBC economist Andrew Grantham as "slightly disappointing", came as the cross party Treasury Select Committee (TSC) warned that the Budget had increased the chances of a double-dip recession.
"It appears that there has been a slight increase in the chance of near-term negative growth and an increased likelihood of positive growth in the outer years," the TSC said in its Budget report. However, the MPs welcomed the Chancellor's decision to build "a degree of caution into the fiscal mandate", taking it as "a signal that if economic conditions demand it he may be prepared to take measures to stimulate the economy, even if these delay the current plans for cutting the deficit".
Opinion on the public finances was split, as the overshoot was relatively small compared with recent years. Economists pointed out that tax receipts were ahead of forecasts, at 7.8pc higher than last year for the three months to June, and expenditure was also on target, up 5.6pc. Gemma Tetlow, senior research economist at the Institute for Fiscal Studies, said: "Growth in central government current spending so far this year has been in line with the forecasts, while revenues have been growing slightly more quickly than forecast. This will be somewhat reassuring news for George Osborne."
Treasury insiders added that the overshoot did not take into consideration the £6.2bn of spending cuts this year that have yet to show up in the numbers. Much of the increase in borrowing was attributed to monthly interest costs, which rose to £3.8bn from £1.7bn last year. However, last year's figure was flattered by low inflation and the overall interest bill is due to rise from £30.9bn last year to £43.3bn. The Bank of England raised further concerns with data that showed banks withdrew £2.3bn of lending from businesses in May, though it added that "demand for bank finance remained muted, with many businesses continuing to pay down debt".
Hungary's IMF revolt augurs ill for Greece
by Ambrose Evans-Pritchard - Telegraph
The collapse of Hungary's talks with the International Monetary Fund and the EU is a chilly reminder that sovereign debt crises do not end with a rescue package and a click of the fingers. As austerity drags on for year after year, democracies react. "We told the IMF/EU that further austerity was out of the question," said Hungary's economic minister Gyorgy Matolcsy, offering no hint that the Fidesz government is willing to back down despite yesterday's surge in Hungarian default costs by 51 basis points.
The Fidesz movement – an amalgam of libertarians and nationalists with a Left-populist tilt – won a crushing victory in April on a campaign of defiance against both Brussels and the IMF. It has been spoiling for a fight ever since. Lars Christensen, of Danske Bank, said events in Budapest are a warning of what may happen in the Baltics later this year, and then in Greece and other parts of EMU-periphery forced to undergo wage cuts and harsh fiscal tightening.
"It is incredible how long Hungary has been struggling to get over its imbalances. It first began austerity measures in 2006, but four years later is still not out of the crisis and there is massive discontent. The Greek problem is even bigger by any measure, whether budget deficit, current account or public debt," he said. "Austerity is extremely hard to sell to electorates. The risk is that this moves from a wider financial and economic crisis to a European political crisis as governments are punished by voters. The approval rating for Lithuanian's prime minister has fallen to 7pc."
Greece is at an early stage of this political sequel. It has won praise from the IMF so far but spending cuts have only just started over recent months, and will grind much deeper over the next three years. Two MPs from the ruling Pasok party have been expelled for refusing to toe the line, and some Greek analysts say the party may ultimately splinter. "The issue is whether they can carry the Greek people when have to make the next round of cuts in 2011," said Chris Pryce, of Fitch Ratings.
Tim Ash, of RBS, said Hungary deserves some sympathy after sticking to agreed cuts last year as the economy contracted by 6pc. It has broadly complied with IMF terms. The budget deficit is just 3.8pc of GDP this year, far lower than Poland, Spain, France, Japan, the UK or the US. Even so, he warned that Hungary is playing a "dangerous game" for a state with a public debt of 80pc of GDP and an external debt of 135pc. "If there is another bout of global risk aversion, Hungary is the first target. It has $40bn of reserves, or five months import cover, but in the end it probably can't survive without IMF money," Mr Ash said.
The country cannot easily devalue to claw its way out of its debt-trap because 63pc of loans from mortgages, households, and companies are in foreign currencies, much of it in the ever-soaring Swiss franc. "A weaker currency will crush households. Countries like Hungary with a debt-sustainability problem need to grow but there is no growth, and they can't reflate," he said. Most investors thought Hungary's woes were over long ago with the approval of the €20bn rescue in 2008 – now mostly exhausted. It was assumed that the rest of Central and Eastern Europe were well on the way to recovery, underpinned by the G20 agreement in April 2009 to triple the IMF's fire-fighting fund to $750bn.
The picture is looking more fragile again. The IMF is nearing its own limits as a lender of last resort after its pledge to back the EU's Stability Facility for Club Med debtors with up $250bn if needed. IMF chief Dominique Strauss-Kahn said yesterday that the Fund was in talks to raise its resources to a $1 trillion as a precaution. "Even when not in a time of crisis, a big fund, likely to intervene massively, is something that can help prevent crises. Just because the financing role decreases, it doesn't mean we don't need to have huge firepower," he said.
Greek Rail System’s Debt Adds to Economic Woes
by Landon Thomas Jr. - New York times
In 2009, bankers for Goldman Sachs and Morgan Stanley pitched the Greek government on a plan to overhaul its money-losing railway system. Among the ideas was to lay off half of the system’s 7,000 workers and have the government take on roughly half of the company’s 8 billion euros in debt. The suggestion did not fly. It was an election year in Greece, after all, and the country was already struggling to keep up the payments on its debt, which is higher in proportion to economic output than in any other nation in the European Union.
The plan was shelved, soon to be overshadowed by the country’s close brush with bankruptcy. Losses at Hellenic Railways, however, continue to mount — at the rate of 3 million euros ($3.8 million) a day. Its total debt has increased to $13 billion, or about 5 percent of Greece’s gross domestic product. Now, as a condition of Greece’s financial rescue, the International Monetary Fund is demanding that a solution be found. The fund and the European Union, which also chipped in to provide the bailout, are requiring that the debt of Hellenic Railways, as well as the off-balance-sheet obligations of other state-owned enterprises, be counted toward Greece’s official debt — which Greece has agreed to do.
Analysts estimate the total to be around $33.6 billion, a sum that would add another 11 percentage points to Greece’s current debt level of about 120 percent of gross domestic product. It would also surely raise questions for many investors about the government’s ability to repay ever-increasing amounts as the overall economy contracts. Some have argued that Hellenic Railways should shut down the majority of its routes, especially in the mountainous Peloponnese region where trains manned by drivers being paid as much as $130,000 a year frequently run empty.
The government, perhaps optimistically, is advocating the sale of a 49 percent stake to the French, who said this year that they would take a look. But it remains unclear how the French rail network, already burdened with its own high levels of debt, would be able to assume Hellenic’s liabilities and losses. The debate, a longstanding one in Greece, has taken on new urgency of late. For the better part of a decade, Greece has provided sovereign backing to Hellenic Railways, thus allowing it to borrow billions from accommodating foreigners even though the company’s finances are so skewed that it pays three times as much on interest expenses than it collects in revenue.
The precarious nature of euro zone finances has made it increasingly difficult for state rail companies to raise capital throughout Europe. Standard & Poor’s recently downgraded the debt of the French and Portuguese national rail operators, and earlier this month Moody’s placed the Spanish train operator on review for a possible downgrade.
Until now, Greece has been able to use its rail system as a means to support employment while not adding to its official debt number. "This was an accounting trick, another good way for the government to hide its debt," said John C. Mourmouris, a former chief executive of the railway who is now an economics professor here. "But a company with 100 million euros in revenue can no longer borrow 1 billion euros a year."
In the latest annual figures available, Hellenic Railways reported a loss of more than $1 billion in 2008, on sales of about $253 million. Of course, shaky finances are not uncommon among rail operators in Europe. Many are poor cash generators. Their prices are kept low as a matter of social policy, forcing the companies to become heavy state-backed borrowers to finance upkeep and expansion.
Even so, the Greek railway is in a category by itself. According to an analysis by Mr. Mourmouris, for Hellenic Railways to just break even, it would need to increase passenger traffic by a factor of 10, an outcome that seems unlikely. Greece has a well-developed road network, a relatively short distance separates its main cities and the railway’s shabby reputation makes it an unpopular travel option for most Greeks.
In spite of about $3.2 billion of investment since 1997, outside of the main route between Athens and Thessaloniki, the network seems in many respects patchwork and at times chaotic. Earlier this month, for example, a trip from Athens to Diakopto, a seaside town on the northern coast of the Peloponnese, took more than four hours. The journey required train passengers to complete a second leg by transferring to an overcrowded bus that was delayed for an hour. The result was a near riot as enraged passengers hurled abuse at overwhelmed train officials. The same trip by car would take less than two hours.
"It is crazy," said Nikolaos Kioutsoukis, the union chief for the railway. "It’s not surprising that people prefer to go by car." Even he accepts that train travel in Greece is not financially viable on many routes. He blames low prices, misguided investment and political meddling for the railway’s poor condition, and says the government should make new investments to modernize the network. He opposes privatization and says that if jobs and benefits are threatened, the union will strike.
Haris Tsiokas, the general secretary for the Greek Transport Ministry, contends that the government’s plan to close at least 35 loss-making routes and cut 2,500 jobs (1,000 via mandatory retirement, with the rest being moved to other government jobs) will make Hellenic Railways attractive to foreign investors. But he concedes that the pressure is building for the railway, which, for now at least, does not have access to debt markets. "We are struggling to avert the closure" of the rail system, he said in response to questions sent by e-mail. "We want Greece’s future railway to be competitive with road transport services."
But reaching such a goal may be impossible, especially when the average salary of a rail employee is over $78,000. Employees benefited from politically inspired pay increases over the last decade. Between 2000 and 2009, the cost of the company’s payroll soared by 50 percent even as overall personnel decreased by 30 percent.
In the eyes of Costis Hatzidakis, the former transportation minister, talk of streamlining, reform and the search for a foreign investor is mere cosmetics when compared with the weight of the rail system’s debts — the bulk of which will mature in 2014. "When I was minister I said I was not going to privatize" Hellenic Railways, he said, "because I knew I couldn’t find an investor silly enough to invest in a company with so much debt."
Bank of Italy Says Financial Crisis Fosters Mafia-Driven Money Laundering
by Steve Scherer - Bloomberg
The mafia has cranked up money laundering activities in Italy after the credit crunch prompted banks to stop lending, leaving a funding gap that criminal capital has filled, according to the Bank of Italy. "The crisis has given organized crime room to thrive because access to credit has become more difficult," said Anna Maria Tarantola, the central bank’s deputy general director, in a July 12 interview in her Rome office. "Whoever holds large amounts of cash, like crime groups, can make investments that aren’t possible for others. They can now invest in fully legal businesses."
The central bank’s financial intelligence unit tracked 15,000 suspicious transactions in the first half of 2010, up 52 percent from a year earlier, and exceeding the total for all of 2008, said Tarantola, who’s in charge of banking oversight. Money laundering occurs when criminals hide illegal income by funneling it through legitimate channels. Last year investigators seized Rome’s Café de Paris, famous for its appearance in Federico Fellini’s 1960 film "La Dolce Vita," alleging it was owned by the Calabrian ‘Ndrangheta mafia. Sicily’s Cosa Nostra mafia has used supermarket chains it owns for similar purposes, according to court reports in Palermo.
Italy’s economy, Europe’s fourth biggest, shrank more than 5 percent last year and the central bank forecasts growth of 1 percent for 2010. Bank lending slowed in 2008 and 2009. Central bank Governor Mario Draghi said July 15 during a speech to Italy’s banking association that "demand for credit is increasing, but there’s the impression that for many businesses, especially the small ones, demand isn’t being fully satisfied."
Organized crime groups boosted their revenue by 4 percent to 135 billion euros ($174.6 billion) last year, according to estimates from Rome-based anti-racketeering group SOS Impresa. Mob arrests have underscored the growing role of the mafia and money laundering in the legal economy. A sweep against the ‘Ndrangheta, Italy’s wealthiest organized crime group, netted more than 300 suspects last week and showed how the organization has taken root around Milan, the country’s financial capital.
Today authorities sought 67 alleged ‘Ndrangheta members near Milan and in Calabria for drug trafficking, extortion and usury, and seized assets worth 250 million euros, according to an e-mailed statement from Italy’s finance police. Authorities consider the ‘Ndrangheta (pronounced en-DRANG-eta) to be Italy’s most dangerous mafia, surpassing Cosa Nostra, because of funds earned from smuggling cocaine into Europe from South America.
Investigators in Rome have accused managers at Telecom Italia Sparkle SpA and FastWeb SpA of running a 2 billion-euro tax fraud and money-laundering program from 2003 to 2007, according to a February arrest warrant. The companies, through their lawyers, said they were unknowingly involved in the scam and deny any wrongdoing. The financial intelligence unit alerted police about suspicious operations involving Telecom Italia Sparkle and FastWeb, Giovanni Castaldi, head of the unit, said in the same July 12 interview.
Of the 21,000 suspicious reports in 2009, the central bank judged that 14,800 warranted further investigation and 4,000 were later labeled crimes and reported to prosecutors, Tarantola said. This is proof the Bank of Italy is spearheading the crackdown on money laundering, she said. "More than 20 percent of the reports have led to criminal investigations," Tarantola said. Draghi urged senior bank executives last week to lead the fight against money laundering after inspections this year at 120 lenders in high-risk mafia areas showed that poor training and management led to inadequate communication of suspicious transactions.
Crime Hurts Growth
The International Monetary Fund estimates that money laundering amounts to an annualized 2 percent to 5 percent of the worldwide gross domestic product. Laundering in Italy may equal as much as 11 percent of GDP, according to former chief mafia prosecutor Pier Luigi Vigna. The central bank is conducting its own studies to evaluate the scale of the problem in Italy, Tarantola said. Credit costs are higher and growth is lower in the southern regions of Italy, where organized crime is most prevalent.
"There’s a very strong correlation between economic growth and organized crime," Tarantola said. "During the period 1983 to 2007, the five regions with the most mafia activity are the ones that had the lowest per capita growth." The financial intelligence unit has ordered banks to scrutinize withdrawals or deposits that involve 500-euro bills, Tarantola said.
Big bills facilitate money laundering since they make large sums of cash easier to hide and transport, the Bank of Italy said in a 15-page internal report last year. As much as 6 million euros can fit in an overnight bag, and 10 million euros in a 45-centimeter (18-inch) safe-deposit box, the document said. The Bank of Canada withdrew its 1,000-dollar ($961) bill in 2000 to fight organized crime and money laundering.
Prime Minister Silvio Berlusconi’s government passed a law last year granting amnesty to tax evaders who agreed to repatriate savings stashed abroad. That led to about 100 billion euros being declared to authorities and more than 5 billion euros in tax revenue. Of the 206,000 transactions related to the amnesty, 340, or 0.2 percent of the total, have so far been flagged as "suspicious," said Castaldi.
The Paris-based Financial Action Task Force, set up in 1989 to fight money laundering, sent a letter to Italian Finance Minister Giulio Tremonti in October expressing "concerns" about the amnesty. The task force drafted a new set of principles this year for countries passing tax amnesties.
Spain’s unemployment devastates residents, adds country to European nations in crisis
by Doug Saunders - Globe and Mail
If you could peer into the very centre of the converging economic forces tearing at the fabric of Europe, you would find a small, politely bewildered man named Jaime Cadena. This week, Spanish Prime Minister José Luis Rodríguez Zapatero became the latest European leader to announce huge cuts to government departments and programs in order to save his country from becoming another bankrupt victim of the continent’s debt crisis. At the same time, Mr. Cadena discovered his own personal place in that crisis.
The 44-year-old construction worker sat at the folding table in the tiny living room of his basement apartment on the outskirts of Barcelona and tried to grasp the larger meaning of a letter from the bank informing him he no longer owned the property. The apartment will be auctioned at a fraction of the price he’d paid for it four years ago, when his fast-rising salary seemed a sure ticket to middle-class stability for his family. If a buyer is found this week, he and his four teenaged children will be evicted. As Spain has no personal-bankruptcy law, he will still owe the bank almost €200,000 – more than the current market value of the apartment – even if he loses it. "It’s like a terrible weight I’m forced to carry," Mr. Cadena says. "I feel like the whole country’s problems have fallen on my back."
With an unemployment rate of nearly 20 per cent, the highest in Europe, it could be a long time before he finds more than the occasional month-long construction job. But the spending cuts launched by Mr. Zapatero this week will likely lead to reductions in the welfare and unemployment-insurance programs that were Mr. Cadena’s only hope of staying aloft until jobs materialize again. Mr. Cadena’s family are part of an estimated 1.4 million Spaniards now facing court action over unpaid mortgages.
During the late 1990s and 2000s, a freewheeling mortgage market gave Spain the highest rate of homeownership in Europe and possibly in the Western world, at 85 per cent. But property values quickly collapsed across Spain – falling more than 40 per cent in Barcelona – at the same time as 2.5 million jobs were wiped out, so there are now a million Spanish families in which all the members are unemployed. In economic terms, Spain’s simultaneous property-bubble collapse and debt crisis mean the country will face years of adjustment to a lower living standard and a less generous government. Given the country’s comparatively strong underlying economy, it does not face a Greek-style lender panic, but it will likely be more than a decade before its economy returns to its previous levels.
The new Europe
In human terms, it means millions of Europeans who had been given a foothold in the middle-class world of property ownership, secure employment and university education have now been plunged into lives of rented rooms, paltry minimum-wage jobs and dependency on an increasingly feeble state. Many face huge burdens of debt. While it now seems likely the euro currency will remain intact after Germany and France acted to secure the debt of their faltering neighbours, and most economies will recover, there is a widespread sense this year’s harsh austerity measures will mark the end of "the social Europe": the continent’s systems of social safety nets, job-security guarantees and early-retirement protections that made middle-class life sustainable for those able to enter it.
In Spain, the government this week asked the people to share a major national sacrifice in order to prevent a disastrous future. "I want to tell you that this is a transcendental moment for Spain, a crucial moment for its immediate future and for the coming decades," Mr. Zapatero told parliament on Wednesday. "We need to adopt measures to reduce the impact on our economy of the worst crisis we have known, and at the same time we need to drive forward the most intense economic transformation of our country in recent times."
Across Europe, governments are preparing enormous cutbacks. In Britain, Prime Minister David Cameron this month asked ministers to draw up plans for a 40 per cent cut in every department. Italy this week passed a budget cutting €25-billion over two years, and Ireland was warned by the International Monetary Fund that its brutal slashing may not be enough to keep debt in check. But the relatively manageable fiscal crisis in many European countries – Spain’s debt situation, like Britain’s, is roughly comparable to the one faced by Canada in the early 1990s – is disguising a far more dire human situation that leaves millions of Europeans fearing for their future.
The middle-class dream
Mr. Cadena’s case is typical in many respects. He is, along with one-10th of all Spaniards today, an immigrant – in his case from Ecuador – who worked hard for a dozen years, married, raised a family and was stably employed enough to became naturalized. A house seemed a logical next step; in fact, his neighbours told him, it was insane to continue renting. In 2006, a Barcelona bank offered him a "free" mortgage – with no down payment – that was offered, signed and closed in one day. His salary of €1,100 a month was combined with his wife’s earnings of €600, and the bank asked them to claim they worked weekends (they didn’t) in order to make their income appear high enough to qualify them.
Before he had a chance to think about it, Mr. Cadena was given the keys to the apartment and a 2-centimetre-thick package of fine-print pages he either couldn’t or didn’t read, and was told the mortgage payments would be €900 a month, withdrawn from his account. He had no idea how much he’d paid for the 3-bedroom basement apartment (only this year did he realize it was an extraordinary €253,000) or the interest rate (5 per cent above prime).
The monthly payments, he soon learned, were calibrated to rise over time, first to €1,100 euros and then, in 2009, to €1,600 – a mortgage structure, also popular in the United States, that only made sense under the assumption both the borrower’s income and the house’s value would rise quickly and constantly. They didn’t. The collapse of Spain’s property bubble coincided with the rising mortgage rates faced by Mr. Cadena (and many others). In early 2009, his construction company cut his shifts to six hours per day; in November they folded completely.
His wife left him, apparently frustrated by his sudden loss of fortune, and he is now a single father watching over children aged 14 to 21 who face even worse prospects than him: Spain’s youth unemployment rate is more than 40 per cent. Two years ago, he expected to be using his home equity to pay for post-secondary educations for them; now he is worried they might fall into gangs and drugs in an apartment neighbourhood that is becoming a ghost town.
Mr. Cadena spends his days looking for jobs, but so far this year, he has only had a month of steady work. Beyond that, he is dependent on the state. At the moment, unemployment-insurance payments give him €1,100 a month, but will end in November, a year after they began; after that, he will rely on welfare payments of €420 a month.
It is widely believed Mr. Zapatero will have to slash Spain’s welfare and unemployment-insurance programs in order to meet his deficit targets, although he has refused to speculate on the possibility. If these benefits are cut, millions of people like Mr. Cadena will be thrust into even worse situations. "I talk to hundreds of people in this position, and many of them just decide to take their own life," says Adria Alemany, head of a housing-rights group pushing for an end to the mortgage policies that cost Mr. Cadena his home. "And why not? What is there to live for? Fighting back for them is the only way to survive."
For Mr. Cadena, a surprisingly fit and cheerful man in the face of personal doom, survival is for his children. "I had my chance," he says, "and I hope they will do better in their time. I’ll need the rest of my life to get out of this."
Swiss endure safe-haven agony from euro flight
by Ambrose Evans-Pritchard - Telegraph
Switzerland is fighting a losing battle to stop massive inflows of funds from investors fleeing sovereign risk in the euro area and the rest of the world, raising the risk of a violent spike in Swiss franc if global debt jitters return. The Swiss National Bank (SNB) said it lost over 14bn francs (£8.8bn) in the first half of the year in a forlorn attempt to hold down the currency against the euro. "If we have a US slowdown with a fresh financial crisis, everybody is going to want to buy the Swiss franc, along with bottled water, tins hats, and a shotgun," said David Bloom, currency chief at HSBC. "Now that Japan’s debt is around 200pc of GDP the franc has displaced the yen as the ultimate safe haven."
The franc has appreciated dramatically against the euro since the debt crisis surfaced in Greece and set off a broader worries about the viability of EMU. It strengthened from CHF 1.52 at the end of last year to a record CHF 1.31 earlier this month. The SNB spent CHF80bn in one month alone trying to prevent the Swiss economy being pulled into a deflation spiral, but each attempt to buy euros has failed to secure any lasting effect. "They are betting against the fundamental trend, which never really works," said Neil Mellor from the Bank of New York Mellon.
Hans Redeker, head of currencies at BNP Paribas, said the surging franc had been driven by capital flight from the eurozone. "If there is any further tension in the EMU banking system, the franc will immediately rise further." Handelsblatt reported that German citizens in Bavaria are crossing the border to open franc accunts in Zurich as a precaution, repeating a time-honoured tradition in times of stress. The Swiss economy is too small to absorb large inflows without causing huge disruption. "Without intervention by the SNB, the franc might be on its way to parity against the euro," said Jürgen Büscher, founder of Büscher Private Asset Management in Zurich.
"What’s causing all the trouble is a `carry trade’ unwind by real estate companies and people in Eastern Europe who borrowed in francs to buy houses. They are in effect being bailed out at the cost of the Swiss taxpayer. In the end I think the euro will recover and the SNB will get out of this without a loss," he said. Data from the Bank for International Settlements shows that external lending in Swiss francs reached $643bn in 2007 as borrowers from the Baltics to Poland, Hungary, and the Balkans, and even Austria tapped into Europe’s lowest interest rates, often pushed by their own banks. In Hungary it became difficult to obtain a loan in local forints. The SNB warned then that this carry trade was hazardous. "A little common sense would not go amiss," it said.
The Swiss government may need to consider even more radical action if the euro fails to stabilize. Switzerland imposed negative interest rates on deposits from 1972 to 1978 to repel capital inflows. Rates reached minus 0.40pc. A study by JP Morgan said the results were "not compelling". The franc rose by 75pc over that period. The SNB’s actions this year have set off a raging debate within the Swiss elite. Kurt Schiltknecht, the banks’s former chief economist, said the euro purchases were a grave error. "We know from past experience that such intervention achieves nothing. You can’t really talk about deflation. Prices are not falling systematically anywhere, and we have seen rising property values and lower unemployment," he said. The growth rate of the M3 broad money supply has crept up from 5.4pc in April to 7.7pc in June.
Ironically, Switzerland itself looked wobbly at the height of the credit crisis, thanks to the global exposure of its banks and vast losses at UBS on US property debt. Credit default swaps measuring bond risk suggested then that the country was losing its crown to oil-rich Norway. "What has changed everything again is that the banking crisis has mutated into a debt crisis," said Mr Bloom. Switzerland’s budget deficit is just 1pc of GDP; gross public debt is 40pc; the current account surplus is 9pc; unemployment is 3.9pc. Above all, the eight million Swiss are still world’s unchallenged uber-rich with half a trillion dollars of external assets to back them up. "Whatever the problem, they can cover it," said Mr Bloom.
Facing Pension Woes, Maine Looks to Social Security
by Mary Williams Walsh - New York Times
Lawmakers in Maine have found an unusual tool for tackling their state’s pension woes: Social Security.
Just as workers in the private sector participate in Social Security in addition to any pension plan at their companies, most states put their workers in the federal program along with providing a state pension. Maine and a handful of others, however, have long been holdouts, relying solely on their state pension plans. In addition, most states have excluded some workers — often teachers, firefighters and police — from the national retirement system and its associated costs, 6.2 percent of payroll for the employer and an equal amount for the worker.
Now, Maine legislators have prepared a detailed plan for shifting state employees into Social Security and are considering whether to adopt it. They acknowledge it will not solve their problem in the short term but see long-term advantages. Some variation on this idea could ultimately appeal to other states grappling with their own exploding pension costs and, in extreme cases, quietly looking for help from Washington. In troubled states, some employees have wondered whether they might be allowed to begin paying in and collecting from the federal system even before they have contributed a career’s worth of taxes.
The potential effect on the Social Security program is hard to estimate. Maine’s proposal would mean new members and a small additional source of payroll tax revenue for the federal system. Even if it fully embraces the proposal, Maine will have to come up with a considerable sum to sustain its existing pension plan, presumably through some combination of taxes and service cuts. After a phase-in period, Social Security would cover part of state retirees’ benefits, with the state pension as the remainder. Many pension plans in corporate America coordinate their benefits in this way.
The proposal has the advantage of not reducing promised benefits, guaranteed by the constitution in many states. The change would not be cheap, but it would reduce the role of Maine’s pension fund and thus the risk of having to suddenly cover giant losses down the road. A Social Security spokesman said the agency did not expect many of the holdout states to join, citing the cost of participation. The only other state known to have talked recently about adding Social Security is Louisiana.
More than six million public employees work outside the Social Security system, including roughly 1.7 million teachers in California, Illinois and Texas, and nearly two million employees of all types in Alaska, Colorado, Massachusetts, Nevada and Ohio, as well as Louisiana and Maine. For years, these and other states have insisted they could provide richer pensions at a lower cost, both to workers and taxpayers, because of investments.
Some of those states’ pension plans now have shortfalls so large that they need outsize contributions. Virtually all state pension funds have had big losses in the last two years, but the go-it-alone states appear especially vulnerable. Not only are these states trying to provide richer benefits with smaller contributions than the payroll tax for Social Security, but they have promised to do it for workers who can retire 10 and sometimes 20 years younger.
With pension costs ballooning and taxpayers lashing out, many workers in states with deeply underfunded plans fear their benefits will be cut. Those being asked to put more into their pension funds complain they feel caught up in Ponzi schemes. Some wish they had been part of Social Security after all. "Had I known back then, I would not have stayed in Illinois," said John Gebhardt, a university employee in that state, which keeps teachers and university personnel out of Social Security. He has even offered to pay both his own and his employer’s payroll tax to join Social Security, but was told no.
Maine lawmakers who support shifting state workers into Social Security say they believe it would be fairer. Social Security may not be sexy, but it is portable. A recent study in Maine underscored the penalty paid by the mobile work force. Only one in five state employees stays around long enough to get a full pension. The majority leave, taking neither a pension nor any Social Security credits with them. This practice, not investment gains, has sustained the state’s pension system.
"The current system is immoral," said Peter Mills, who, as a state senator, started the push to join Social Security. "It takes younger people and feeds off of them. You can withdraw from teaching at age 40 and realize you’ve got nothing to look ahead to for your old age." Dallas L. Salisbury, president of the Employee Benefit Research Institute, said he was surprised by how few public workers ever got pensions in Maine, where he provided advice on a pension overhaul. He said he checked and found similar turnover in other states.
Whether Maine joins Social Security or not, painful choices must be made. The state pension fund lost $2.25 billion in 2008, and taxpayers will have to replace the lost money. But they have less time to do so than most states, thanks to tough financing rules in the constitution. Projections show that Maine will not have enough money to do much else in the coming years if it adheres to those rules. "It’s going to rip the guts out of our budget," said Mr. Mills. "I don’t think you can find a budgetary parallel in my lifetime, and I’m 67."
Unlike laggard states, including Illinois and New Jersey, Maine had in recent years been making its required pension contributions annually, and it avoided the common mistake of sweetening benefits when markets were strong. Its looming fiscal crisis stems primarily from investment losses, points out Sandy Matheson, executive director of the state plan. "Maine is almost like a petri dish," she said, showing how things can go awry even if a state is responsible.
Mr. Mills, a Republican, initially envisioned shifting workers into Social Security and a 401(k) plan. But he now views Social Security combined with a traditional pension as a safer option. That puts him on common ground with Democrats in the statehouse. The proposal may meet resistance, however, because it does not fill the gaping hole in the state’s pension fund. A shift into the federal program is also hard to plan because Social Security has a financial imbalance — one that will worsen as the population ages. At some point, Congress is expected to either raise taxes or cut benefits.
Still, Social Security’s future is easier to predict than that of a state pension fund, because its pressure stems from broad demographic trends, not the vagaries of the stock market. Social Security keeps its reserves in conservative Treasury securities. "You’ve got reviews taking place all over the country," said Mr. Salisbury. Most places are asking painful questions about their investment strategies. But what Maine has discovered, he said, is just how expensive it really is to provide a guaranteed retirement benefit.
California Official's $800,000 Salary in City of 38,000 Triggers Protests
by Christopher Palmeri - Bloomberg
Hundreds of residents of one of the poorest municipalities in Los Angeles County shouted in protest last night as tensions rose over a report that the city’s manager earns an annual salary of almost $800,000. An overflow crowd packed a City Council meeting in Bell, a mostly Hispanic city of 38,000 about 10 miles (16 kilometers) southeast of Los Angeles, to call for the resignation of Mayor Oscar Hernandez and other city officials. Residents left standing outside the chamber banged on the doors and shouted "fuera," or "get out" in Spanish.
It was the first council meeting since the Los Angeles Times reported July 15 that Chief Administrative Officer Robert Rizzo earns $787,637 -- with annual 12 percent raises -- and that Bell pays its police chief $457,000, more than Los Angeles Police Chief Charlie Beck makes in a city of 3.8 million people. Bell council members earn almost $100,000 for part-time work.
City Attorney Edward Lee said the council members couldn’t discuss salaries in public without advance notice. The council then adjourned for a private session. About an hour later, the council members returned, and Hernandez read a statement saying the city would prepare a report on the salaries and seek public comment at the next council meeting, scheduled for Aug. 16. Residents shouted in protest. Lee said he would have the room cleared if people continued to speak out of line. Police Chief Randy Adams said the fire department wanted to end the meeting because the crowd outside was blocking the door.
Then, in what appeared to be an effort to ease tensions, Hernandez announced that the meeting to discuss salaries would be held instead on July 26. After the meeting, Bell resident Ali Saleh read a statement from a newly formed group called the Bell Association to Stop the Abuse. He called for an independent audit of city salaries and contracts.
On July 1 Bell took control of many of the city functions of neighboring Maywood, a city whose council members voted to contract out almost all services. Saleh also asked that Bell stop that process until the city’s salary investigations were resolved. Bell has sold two general obligation bond issues totaling $50 million in the past six years, according to prospectuses for the bonds and information in the city’s annual financial statement for 2009. In that time, its debt has risen to $1,972 per capita in 2009 from $599 in 2004, according to its annual financial statement.
Inquiry Under Way
The city’s personal income was $24,800 per capita in 2008, according to its financial statement. That compares with an average of $32,819 nationwide, according to 2010 figures from the U.S. Bureau of Economic Analysis. Bell’s general fund revenue declined 4.6 percent to $14.1 million for the fiscal year that ended June 30, 2009, according to the city’s financial statement. The city’s expenses rose 2.3 percent to $15.9 million in same period.
The Los Angeles County District Attorney’s Office has begun an inquiry into Bell council member pay, according to Dave Demerjian, head of the office’s Public Integrity Division. He said Bell council members were receiving $8,083 a month, mostly by serving on city-related commissions. "We’re reviewing the council member salaries to see if they conform to state law," Demerjian said in a telephone interview.
California law limits the salaries of council members to several hundred dollars a month, depending on the size of the city, according to Hector De La Torre, a state assemblyman from nearby South Gate, who sponsored legislation in 2005 that limits how much council members can get paid from other city-related assignments to $150 a month.
De La Torre said that after his bill was passed, Bell’s City Council voted to operate under its own charter, rather than adhere to state laws on how cities should be run. "It seems obscene to me," De La Torre said in a telephone interview. "People making $30,000 a year are paying taxes so that their council members can make $80,000."
Adams, Bell’s police chief, said in an interview after the council meeting that he had retired as chief of police in the much larger city of Glendale, California, when Bell officials approached him. "I told them they would have to pay me what I was making in retirement and the $165,000 I would make as chief of police," Adams said. Adams said he had been brought in to end corruption in Bell’s police department. "Some of the former members of this force are in the federal penitentiary," he said.
Hernandez, the mayor, defended the salaries in an interview with the Los Angeles Times. "Our streets are cleaner, we have lovely parks, better lighting throughout the area, our community is better," Hernandez said, according to the newspaper. "These things just don’t happen, they happen because he had a vision and made it happen." Carmen Avalos, the city clerk in South Gate, said she attended the Bell council meeting to help educate people about the political process. "This is what we are trying to avoid," she said in an interview at the meeting. "The lack of fiduciary responsibility, the lack of transparency."
1 million Ontario workers face wage freeze
Ontario union leaders and other officials will sit down with Finance Minister Dwight Duncan on Tuesday to discuss a possible wage freeze for more than one million workers. Duncan is faced with a $21 billion deficit and has already said some public-sector workers — bureaucrats, teachers and nurses — will face wages freezes when their collective agreements expire. Now it appears Duncan wants to extend the freeze throughout the Ontario civil service.
Not only would 700,000 unionized workers face a wage freeze, but 350,000 managers would as well. Union representatives don't appear ready to accept a freeze, saying the employees aren't responsible for the budget problem. "The shortfall was never caused by people's wages," said Fred Hahn, president of CUPE Ontario, which represents 230,000 workers. "The shortfall was caused by a global economic meltdown that workers in the province had nothing to do with,"
Hahn said his members have been anxious ever since Duncan hinted in his March budget that wage freezes might be coming. "Why don't we have a bigger discussion about how do we invest to create jobs, get people back to work in various parts of the province?" Hahn asked.
Smokey Thomas, president of the Ontario Public Service Employees Union, has cut his vacation short to attend the meeting with Duncan. He said his 130,000 members would not accept a freeze. Duncan has put the employees in a position where "our answer has got to be, 'No,'" he said. Thomas said many of his members are part-time workers who would be disproportionately hurt by any wage freeze. "I mean if you are only making $20,000 a year, a two per cent raise isn't much, but it certainly helps."
As many as 750 contracts would be affected. Union leaders say they will listen to what Duncan has to say but they don't expect any decisions to come out of the two-hour meeting. The government estimates it could save $750 million by next year if the wage freeze comes into effect.
BP well site leader testifies that Halliburton had warned of potential problem
by David S. Hilzenrath and Marc Kaufman - Washington Post
On April 16, four days before the Deepwater Horizon exploded in a fireball, one of the two "company men" who oversaw drilling operations on the oil rig for BP boarded a helicopter and headed for shore. Ironically, he went to a training program on blowout preventers.
Ronald Sepulvado, who had been working on the Deepwater Horizon for more than seven years, turned off his cellphone after he landed, stopped checking e-mail regularly and did not read an April 18 warning from contractor Halliburton that the well faced a potentially severe gas flow problem. The next news he received about the rig came in the wee hours of April 21, when his son called him at a hotel and asked if he knew that the Deepwater Horizon was burning.
Sepulvado gave that account Tuesday as the first of the BP well site leaders to testify before a government panel looking into the disaster in the Gulf of Mexico. Seated at the witness table in an airport hotel here, he recalled:
• Seeing an April 15 Halliburton report that said there was potential for a minor gas flow problem on the Deepwater rig. "I just don't read every line of that report because it's about 20 to 30 pages long," Sepulvado said. He said he was not aware of any warning to the crew about a potential problem.
• Being present during an April audit that found that the rig's blowout preventer was well past its required inspection date. He said he didn't know inspections were required every three to five years.
• Continuing to drill although the rig's blowout preventer was having problems with certain valves and "was leaking hydraulic fluid." Drilling at the Macondo well was not suspended because, Sepulvado said, "we assumed that everything was okay.
When the blowout preventer was put to the ultimate test April 20, it failed catastrophically. Sepulvado said he has been a well site leader for 33 years. Today, he has a new assignment: helping to drill one of the relief wells to kill the Macondo. He spoke Tuesday at a hearing being conducted by a joint investigation board of the U.S. Coast Guard and the Bureau of Ocean Energy Management, Regulation and Enforcement (an agency formerly known as the Minerals Management Service).
The hearings have highlighted a history of delayed maintenance and mechanical problems aboard the Deepwater Horizon. While questioning Sepulvado, panel member Jason Mathews, of the agency, said a BP audit in September found a variety of problems, some of which had the potential to affect the rig's emergency preparedness. He said "a recommendation was made to the well team to suspend operations until many have been satisfactorily addressed."
Two other BP company men -- who were alternating shifts as top BP representatives on the rig after Sepulvado left -- were scheduled to testify but withdrew. One was Robert Kaluza, who was less familiar with the Deepwater Horizon and who took over what was known as a troubled operation at a sensitive time. He invoked his Fifth Amendment right against self-incrimination through his attorney. Donald Vidrine canceled for medical reasons, an explanation backed up with documents from his doctor, said Coast Guard Capt. Hung M. Nguyen, co-chairman of the investigating panel.
BP and government officials moved closer Tuesday toward agreement on another technique for dealing with the well, which was capped last week. Kent Wells, BP's senior vice president, said the company would like to implement a "static kill" of the well, which involves sending mud and later cement into the well through the cap. The final closing would still have to be performed by a relief well "bottom kill," now scheduled to begin in late July or early August if the weather remains good.
Wells said the company is eager to perform the static kill if the government approves it. Retired Coast Guard Adm. Thad W. Allen, the national incident commander, said he expected to have a final decision Wednesday. While the operation could speed the final closing of the well -- an important consideration during the gulf's hurricane season -- it would also leave forever unanswered the question of how much oil has gushed out of the well. The amount of oil that escaped will play a role in determining the dollar amount the company will have to pay the government and others.
BP tests continue as officials explore new option
by CNN Wire Staff
Critical tests on the capped well in the Gulf of Mexico will continue Wednesday as scientists work on the ultimate solution to end the oil disaster. Pressure testing on the capped well was extended for another 24 hours Tuesday, said Thad Allen, the federal government's point man on the spill. The tests on the new, tightly fitting containment cap began Thursday and are designed to determine the effectiveness of the cap.
Though the new cap has stopped the incessant flow of oil into the Gulf, government officials and BP have said that the cap on the well is only a temporary fix for the oil disaster that started on April 20. BP officials are still working on the permanent fix, relief wells that are slated to be in place by the end of July. Officials are also exploring a new tactic called "static kill" to help stop the oil's flow.
The "static kill" would involve pumping mud into the well to force oil back into the reservoir below, officials from BP have said, noting that the option could succeed where similar attempts have failed because pressure in the well is lower than expected.
Geologist Arthur Berman said on CNN's "American Morning" on Tuesday that the relative simplicity of a static kill makes it an attractive option for BP. "I think the reason that they're considering it is because they've yet to intercept the well bore," Berman said. "They're very close, a few feet away with the relief well, as everyone knows. But to actually intersect the 7-inch pipe does involve a bit of technology and accuracy, whereas if they do the static kill through the existing well bore at the top, there's less uncertainty about their ability to actually get the mud into the pipe."
No visible oil has flowed from the well since Thursday, when BP closed all the valves in the new custom-made cap that was installed July 12. Federal officials said Tuesday that one reported leak is coming from another old well a couple miles away and is inconsequential. British Prime Minister David Cameron, who was visiting Washington on Tuesday, said he "completely understands" the anger that "exists ... across America" regarding the oil well operated by BP that exploded in the Gulf of Mexico three months ago. "It is BP's role to cap the leak" and compensate people affected by it, he said during a visit with President Barack Obama. Cameron said he is in regular touch with the leadership of BP, a British-based company.
Two House subcommittees held a joint hearing Tuesday to investigate the role of the Interior Department in the Deepwater Horizon disaster. Legislators are trying to figure out who's responsible for the crisis and how better government regulation of energy producers might help avert such disasters in the future.
A report in London pointed the finger at BP's beleaguered chief executive Tony Hayward. Hayward is preparing to step down from his position within the next 10 weeks, the Times of London reported Tuesday, citing "sources" close to the company. Hayward and his management choices have drawn a barrage of criticism since BP's Deepwater Horizon drilling rig accident began spewing oil. Its share price hammered, BP is fighting to ensure that it has the resources to pay the billions it now faces in fines, cleanup expenses and compensation claims from local workers and businesses.
There is a "growing expectation" that Hayward will announce his departure in late August or September, the Times reported. "You would be hard-pushed to find anyone within the company who does not think he is irreparably damaged -- both by his own performance and by the event itself," the newspaper quoted one company insider as saying. BP strongly denied the Times' report. "There is no truth in this article," Daren Beaudo, a BP spokesman based in Houston, Texas, told CNN. "Mr. Hayward is not leaving."
BP buys up Gulf scientists for legal defense, roiling academic community
by Ben Raines - Press-Register
For the last few weeks, BP has been offering signing bonuses and lucrative pay to prominent scientists from public universities around the Gulf Coast to aid its defense against spill litigation. BP PLC attempted to hire the entire marine sciences department at one Alabama university, according to scientists involved in discussions with the company's lawyers. The university declined because of confidentiality restrictions that the company sought on any research.
The Press-Register obtained a copy of a contract offered to scientists by BP. It prohibits the scientists from publishing their research, sharing it with other scientists or speaking about the data that they collect for at least the next three years. "We told them there was no way we would agree to any kind of restrictions on the data we collect. It was pretty clear we wouldn't be hearing from them again after that," said Bob Shipp, head of marine sciences at the University of South Alabama. "We didn't like the perception of the university representing BP in any fashion."
BP officials declined to answer the newspaper's questions about the matter. Among the questions: how many scientists and universities have been approached, how many are under contract, how much will they be paid, and why the company imposed confidentiality restrictions on scientific data gathered on its behalf. Shipp said he can't prohibit scientists in his department from signing on with BP because, like most universities, the staff is allowed to do outside consultation for up to eight hours a week.
More than one scientist interviewed by the Press-Register described being offered $250 an hour through BP lawyers. At eight hours a week, that amounts to $104,000 a year. Scientists from Louisiana State University, University of Southern Mississippi and Texas A&M have reportedly accepted, according to academic officials. Scientists who study marine invertebrates, plankton, marsh environments, oceanography, sharks and other topics have been solicited.
The contract makes it clear that BP is seeking to add scientists to the legal team that will fight the Natural Resources Damage Assessment lawsuit that the federal government will bring as a result of the Gulf oil spill. The government also filed a NRDA suit after the Exxon Valdez spill. In developing its case, the government will draw on the large amount of scientific research conducted by academic institutions along the Gulf. Many scientists being pursued by BP serve at those institutions.
Robert Wiygul, an Ocean Springs lawyer who specializes in environmental law, said that he sees ethical questions regarding the use of publicly owned laboratories and research vessels to conduct confidential work on behalf of a private company. Also, university officials who spoke with the newspaper expressed concern about the potential loss of federal research money tied to professors working for BP. With its payments, BP buys more than the scientists' services, according to Wiygul. It also buys silence, he said, thanks to confidentiality clauses in the contracts.
"It makes me feel like they were more interested in making sure we couldn't testify against them than in having us testify for them," said George Crozier, head of the Dauphin Island Sea Lab, who was approached by BP. Richard Shaw, associate dean of LSU's School of the Coast and Environment, said that the BP contracts are already hindering the scientific community's ability to monitor the affects of the Gulf spill. "The first order of business at the research meetings is to get all the disclosures out. Who has a personal connection to BP? We have to know how to deal with that person," Shaw said. "People are signing on with BP because the government funding to the universities has been so limited. It's a sad state of affairs."
Wiygul, who examined the BP contract for the Press-Register, described it as "exceptionally one-sided." "This is not an agreement to do research for BP," Wiygul said. "This is an agreement to join BP's legal team. You agree to communicate with BP through their attorneys and to take orders from their attorneys. "The purpose is to maintain any information or data that goes back and forth as privileged."
The contract requires scientists to agree to withhold data even in the face of a court order if BP decides to fight such an order. It stipulates that scientists will be paid only for research approved in writing by BP. The contracts have the added impact of limiting the number of scientists who're able to with federal agencies. "Let's say BP hired you because of your work with fish. The contract says you can't do any work for the government or anyone else that involves your work with BP. Now you are a fish scientist who can't study fish," Wiygul said.
A scientist who spoke to the Press-Register on condition of anonymity because he feared harming relationships with colleagues and government officials said he rejected a BP contract offer and was subsequently approached by the National Oceanic and Atmospheric Administration with a research grant offer. He said the first question the federal agency asked was, "'is there a conflict of interest,' meaning, 'are you under contract with BP?'" Other scientists told the newspaper that colleagues who signed on with BP have since been informed by federal officials that they will lose government funding for ongoing research efforts unrelated to the spill.
NOAA officials did not answer requests for comment. The agency also did not respond to a request for the contracts that it offers scientists receiving federal grants. Several scientists said the NOAA contract was nearly as restrictive as the BP version. The state of Alaska published a 293-page report on the NRDA process after the Exxon Valdez disaster. A section of the report titled "NRDA Secrecy" discusses anger among scientists who received federal grants over "the non-disclosure form each researcher had signed as a prerequisite to funding."
"It's a very strange situation. The science is already suffering," Shaw said. "The government needs to come through with funding for the universities. They are letting go of the most important group of scientists, the ones who study the Gulf."
Matthew Simmons Discusses BP's Oil Leak in Gulf of Mexico
Ilargi: As promised, more on the breaker boys seen in the photograph at the top:
From the 1906 book The Bitter Cry of the Children by labor reformer John Spargo:
Work in the coal breakers is exceedingly hard and dangerous. Crouched over the chutes, the boys sit hour after hour, picking out the pieces of slate and other refuse from the coal as it rushes past to the washers. From the cramped position they have to assume, most of them become more or less deformed and bent-backed like old men. When a boy has been working for some time and begins to get round-shouldered, his fellows say that “He’s got his boy to carry round wherever he goes.”
The coal is hard, and accidents to the hands, such as cut, broken, or crushed fingers, are common among the boys. Sometimes there is a worse accident: a terrified shriek is heard, and a boy is mangled and torn in the machinery, or disappears in the chute to be picked out later smothered and dead. Clouds of dust fill the breakers and are inhaled by the boys, laying the foundations for asthma and miners’ consumption.
I once stood in a breaker for half an hour and tried to do the work a 12-year-old boy was doing day after day, for 10 hours at a stretch, for 60 cents a day. The gloom of the breaker appalled me. Outside the sun shone brightly, the air was pellucid, and the birds sang in chorus with the trees and the rivers. Within the breaker there was blackness, clouds of deadly dust enfolded everything, the harsh, grinding roar of the machinery and the ceaseless rushing of coal through the chutes filled the ears. I tried to pick out the pieces of slate from the hurrying stream of coal, often missing them; my hands were bruised and cut in a few minutes; I was covered from head to foot with coal dust, and for many hours afterwards I was expectorating some of the small particles of anthracite I had swallowed.
I could not do that work and live, but there were boys of 10 and 12 years of age doing it for 50 and 60 cents a day. Some of them had never been inside of a school; few of them could read a child’s primer. True, some of them attended the night schools, but after working 10 hours in the breaker the educational results from attending school were practically nil. “We goes fer a good time, an’ we keeps de guys wot’s dere hoppin’ all de time,” said little Owen Jones, whose work I had been trying to do.
From the breakers the boys graduate to the mine depths, where they become door tenders, switch boys, or mule drivers. Here, far below the surface, work is still more dangerous. At 14 or 15 the boys assume the same risks as the men, and are surrounded by the same perils. Nor is it in Pennsylvania only that these conditions exist. In the bituminous mines of West Virginia, boys of 9 or 10 are frequently employed. I met one little fellow 10 years old in Mount Carbon, West Virginia, last year, who was employed as a “trap boy.”
Think of what it means to be a trap boy at 10 years of age. It means to sit alone in a dark mine passage hour after hour, with no human soul near; to see no living creature except the mules as they pass with their loads, or a rat or two seeking to share one’s meal; to stand in water or mud that covers the ankles, chilled to the marrow by the cold draughts that rush in when you open the trap door for the mules to pass through; to work for 14 hours — waiting — opening and shutting a door — then waiting again for 60 cents; to reach the surface when all is wrapped in the mantle of night, and to fall to the earth exhausted and have to be carried away to the nearest “shack” to be revived before it is possible to walk to the farther shack called “home.”
Boys 12 years of age may be legally employed in the mines of West Virginia, by day or by night, and for as many hours as the employers care to make them toil or their bodies will stand the strain. Where the disregard of child life is such that this may be done openly and with legal sanction, it is easy to believe what miners have again and again told me — that there are hundreds of little boys of 9 and 10 years of age employed in the coal mines of this state.
John Spargo, The Bitter Cry of the Children (New York: Macmillan, 1906)