"A small girl sits in a tire in the yard of a Hooverville home in Circleville, Ohio"
Ilargi: To order the interactive video presentation (only $12.50!! ) of Stoneleigh's lecture "A Century of Challenges", which is getting lots of love and praise across Europe and North America, PLEASE CLICK HERE or click the button in the right hand column just below the banner.
Ilargi: Fittingly, on the eve of the World Series, it's show time, game time, take your pick, as in a crucial week for the US, or so we're being led to believe, and most still down it hook line and sinker. In reality, though, the die have long been cast, when the vast majority of you weren't looking, for instance because you were focused on yet another election, a stimulus plan or an Quantitative Easing announcement.
Me, I find it increasingly hard and bitter to pay attention. I see numbers float by like those from the BEA that claim US GDP is almost back to where it once was, and consumer spending is doing great. The only downside of it all, word is, is that poverty rates are soaring. Conclusion: there are a few dozen million Americans that the US economy simply doesn't need anymore.
Now, I don't want to get into a discussion about the ethics of this; there's plenty of ass-clowns out there ready to defend the ethical implications of throwing out people by the curb. Still, one thing: some may think you can have a functioning society, with liberty, pursuit of happiness and all, in that situation. And they are dead wrong. You can't have a society that eats its own and still can last. Such a society necessarily and per definition eats itself too.
The only thing that still does interest me in this is that it's all a big headfake. Surging stock markets in the face of millions of 99'ers and various other unemployed and homeless, practically assured by now that their Christmas will consist of trying to find a spot in a manger if they can find one, begging for a few scraps of throw away food for their children, the thought of lights and presents and cheer long re-allocated to the place in their minds where memories reside, if they're lucky enough to have any such memories.
And that's not all. What those GDP and consumer figures tell me more than anything is that some of us have access to the fake virtual money that mark-to-fantasy valuations create, and some do not. That's really the whole entire story.
Another fake election between candidates who all have their campaigns financed by the exact same money sources, many of whom they pretend to oppose in their election rhetoric. Another fake effort, number what(?!), I lost count, in a long line of them, to allegedly "rejuvenate" a real economy that's long since been pushing up daisies, taking more money that could have helped the manger dwellers to a humane existence, and showering it upon the happy few who can get away with losing all their bets and still come back for more time and again.
Hold out your hand for billions, and you will be in high regard and your needs satisfied; hold it out for food, and you will be spat upon and kicked down the road.
Everyone's asking if and how the markets will respond to one set of bad actors being replaced by another one, or "the biggest announcement by the Fed in decades" when Bernanke on Wednesday will reveal how many trillions he doesn't own but still has spending power over, will be passed on to a banking, gambling and mortgage lending cabal that's so far in the red it should have been thrown overboard ages ago.
All this while WaMu is losing over 60% of its market value in one day today. Bad for JPMorgan, its new parent since 2008? You'd think so, but really, why should it be as long as Jamie Dimon can suckle at your painful breast anytime he feels like doing so? If you still don't get the name of this game, I’ll say it once again:
"Heads You Lose, Tails You Die".
Me, I think it's high time for a new life, a new beginning, a new world, since there's something fundamentally amiss here, it's not just superficial things that an election or a helicopter full of money could ever possibly hope to heal.
And yes, it looks like this new life will once again be born in a manger. Or a Hooverville, a Obamaville, or just one of the millions of deserted dilapidated foreclosed (or is it?!) homes across the land. For the sake of the children, I’ll go with a manger.
Ilargi: The title for today's post comes from a Chris Whalen interview with Fox News, see below. I don’t like borrowing lines, but this one's long been a staple at The Automatic Earth. Whalen evokes the exact same picture Stoneleigh's been talking about for years in "A Century of Challenges" (order it here), and I quote:
[Hoover] was probably one of the best qualified people who ever ran for president in the United States, but had the misfortune to win by a landslide in 1928 and preside over a depression about which he could do absolutely nothing. [..] He went down in history as an abject failure and there are lessons this president (Obama) probably should have learned before he ran. The two [candidates] that ran the last time were competing for the poison chalice.
And, unfortunately for racial harmony in this country, Mr. Obama won, and as much I like him considerably more than the alternative, I still think [..] there are dangers to putting him in the Oval Office when America did because I think when someone goes down in flames, I can see that inflaming considerable amounts of tension and I think that's very, very unfortunate for the country as a whole.
Ilargi: In view of all the delusion we encounter these days, wherever we look, I think there's no better antidote than this great interview Stoneleigh did yesterday afternoon with Carolyn Baker.
Psychological Inoculation For A Century Of Challenges: Carolyn Baker Interviews Nicole Foss
An exclusive interview with one of the most astute minds in the world of finance whose insights offer crucial preparation for living in a post-industrial world
November, 2010, Boulder, Colorado: Nicole Foss, also known as Stoneleigh, senior editor of the The Automatic Earth, generously gave me an hour of her time this week during another of her U.S. tours in which she is lecturing on the global financial crisis and answering questions from countless individuals who are preparing for its most dire ramifications. Her online presentation "A Century of Challenges" is a must-watch, complete with Powerpoint slides which de-mystify the world of finance that often leaves our heads spinning and our eyes glazed. I sat down with Nicole here in Boulder a few hours before her presentation in Littleton and asked her some key questions about global economic meltdown and its implications for all of us.
Foss originally studied biology and environmental science and acquired two law degrees. She wanted to understand globalization and its effects on peripheral societies and used her law degrees not to practice law, but to grasp how power relationships work. She was intrigued by how the law codifies and legitimizes existing hierarchies and then facilitates the conveyance of wealth from the periphery to the center. Naturally, she reasoned, "If I want to really understand how the world works, I have to understand money." No, Foss did not earn a degree in finance, but rather, studied it on her own for about 15 years. In addition, she delved deeply into energy studies and connected the dots between the two disciplines.
Foss was born in the UK but grew up in Canada and then spent more time in the UK as an adult, later returning to Ontario. There she ran the Agri-Energy Producers Association of Ontario which focused on farm-based biogas. People began asking her to come and do talks on a variety of topics, and as she continued studying finance, she started pulling all the information together, ultimately creating her current "Century of Challenges" presentations and with her husband and writing partner, Ilargi, the Automatic Earth blogspot which is nearly three years old. They now live in Ottawa.
CB: What is your greatest concern at the moment in terms of the global economic crisis?
Nicole: That it could unfold very, very quickly. Because deflation is a swing of poverty feedback, it can take awhile to build up. If you try to explain to people what's coming, because it doesn't happen instantly, they tend to go back to sleep. The thing they need to understand, however, is that when it does hit a tipping point, a kind of critical mass, then it can unfold exceptionally quickly. Then it's very much like having the rug pulled out from under your feet. So I tell people all the time, prepare now because it's better to be two years too early than five minutes too late. You can't play with this sort of thing. In September, 2008, we came within a few hours of the banking system seizing up, and that could easily happen again. People wouldn't get a lot of notice. For anyone who's not in the meeting room-it will be too late by the time they find out. My worry is that if there are an enormous number of people who just had the rug pulled out from under their feet, they're going to run around like headless chickens, and the human over-reaction to events will be really responsible for a large percentage of the impact.
So what I try to do is provide a kind of psychological inoculation. People are going to be afraid, and they're going to be angry. People who are angry and afraid are easily manipulated. If you look at Orwell's 1984, the Two Minutes' Hate in that book was really to get people thoroughly into that unthinking frame of mind and keep them there so you could basically tell them whatever you want them to believe. So I try to tell people that this is coming-this is what the herd is going to do. When people are angry and afraid, they don't do anything useful; they play an enormous blame game, and they're susceptible to manipulation by demagogues. A whole political culture could take a giant leap in a different direction which could be a substantially negative direction that could then have horrendous impact on everyone else. Until people recognize that that is coming, and see it for what it is, they will be susceptible to it.
I tell people to spend time in the Transition Movement or various other positive initiatives as well, but all these initiatives have in common building things from the ground up in a truly positive, constructive way. This is the head space that people need to be in because if we can blunt the human over-reaction, we can lessen the impact of the event itself. I don't know that I can make this happen on a wide scale, but if I can have the largest possible effect, even if it's not that much, it's something, and we can only do what we can do.
My great worry is that we could see everything unfold very quickly, and then the whole political culture gets derailed in a fascist, theocratic direction.
This is certainly where it's going already in the United States.
Yes, it is unfortunately, and this is a tremendous concern. In the event of this, everyone's life gets much, much more difficult.
In this extraordinary presentation that you're doing called "A Century of Challenges," you argue that ongoing deflation is more of a threat than inflation. Can you briefly explain this?
What we've lived through is essentially a giant credit expansion. Credit expansions create mutually helpful and mutually exclusive claims. They are excess claims to underlying real wealth. Sometimes in the Peak Oil community, people see energy as the only cause of everything, so they would say you have to run out of energy to have a collapse. I would say you really don't because when you create what is effectively a Ponzi scheme, you create excess claims to underlying real wealth. For one thing, it's virtual wealth, so you can create a bubble without an enormous subsidy of energy because you're creating something that isn't really there. But then because it is a Ponzi scheme, it is inherently self-limiting, and it will crash, and then what happens finance becomes the key driver to the down side. So energy is a huge driver going up, and finance is the key driver on the way down because it's much shorter term. So what deflation is, is the extinguishing of excess claims to underlying real wealth. This is the point where people realize they are playing a giant game of musical chairs, and there's only one chair for one hundred people. So you can imagine when the music stops how this plays out. This is no slow squeeze but a frantic grab for a chair-that is, pieces of the underlying real wealth pie.
Once you have the creation of excess claims of wealth, there's nothing anyone can do to prevent those from being extinguished at some point. We have to go through the period where that happens because credit is in excess of 95% of the money supply. The crash of credit, which is the virtual wealth portion, crashes the money supply because the money supply is money plus credit relative to available goods and services. When you collapse the supply of credit, you're collapsing the money supply. That is deflation by definition. So anyone who isn't looking at the role of credit is going to make mistakes as to where things are going.
I mean we really have to take into account the fact that credit is going to crash. There's going to be a massive de-leveraging. People say, "Oh well, they'll print their way out," or "Quantitative easing will just keep things going forever." Only extremely limitedly can you keep kicking the can down the road. And things like quantitative easing are not inflationary because there's no money getting into the real economy. It's a game of smoke and mirrors, ie., "We'll tell people we're pumping all this money in the system to restore confidence. Maybe if we restore confidence, they won't all run out and take their money out of the bank." But it isn't going to work; it only appears to work during the period of a rally. A rally is just a resurgence of confidence and a renewed suspension of disbelief. And when you have the psychology of a rally, that supports whatever anybody's trying to do and makes it look like it works. But it's really the psychology that's making it work.
I think we're about to move to the down side now. The current rally is finishing-it's rolling over and so for QE2, there will not be that supportive psychology, and when that is not there, everything central authorities try to do will fall flat on its face. This quantitative easing is not going to work; it's not inflationary. If you try to print, what ends up happening is that the bond market will kill you, so you end up with your interest rates shooting up, not just for the government, but for everybody. Trying to print your way out of it just gets you to the cliff even faster.
I really see this as critical. You have to go through deflation.
So what do you think is the future of the U.S. dollar?
I think that for a year, maybe longer, it will probably do quite well compared with other currencies. I think there will eventually be a lot of capital flight out of Europe to the U.S. That will probably prop up the dollar significantly whereas the Eurozone is going to get smaller.
So this will keep the dollar strong for awhile?
For awhile, but it's not a long-term bet. Cash is no long-term bet. It's a way to preserve capital through the great de-leveraging, so cash is king during the period where you're going through deflation. Hold cash to start with, then move to hard goods at the point where you can afford it. Hard goods are things like land, tools, and barter goods-all things that perform real functions. Don't go into debt to do it, and don't use up every last penny you have. The next 2 to 5 years are the best times to do this. You ride out deflation in cash, and you ride out inflation in hard goods. I think that beyond a year or two, what you get is a really chaotic currency system. The speculators will have a field day with it. At that point, it doesn't matter what your dollar is worth in terms of someone else's currency but what it is worth in terms of milk and bread.
What do you think about alternative, local currencies?
They are an inherent part of relocalization, but they don't tend to last all that long because one of the reasons they work is that there's economic activity going on. And, if they are very successful, governments tend to shut them down. So what I tell people is, by all means do it, but when you do, regard yourself as living on borrowed time. If you do this with a fired up sense of urgency, you can probably accomplish a lot in a year or two.
Time banks are great too because they build relationships of trust. This is something that is absolutely critical, and it's one of the reasons that Transition works. What you get in times when you're having any kind of contraction, the trust horizon collapses. So all of a sudden, the institutions people used to trust are now stranded beyond the trust horizon. And where you do not have trust at that level, you lose political legitimacy, and without political legitimacy, without a general sense of buy-in at that level, you end up with surveillance and coercion as a substitute. That is where I think the national institutions are going. As the trust horizon collapses, the things that work are the things that are still within it. This is why local currencies and time banks work. Relocalization works because you can get the same kind of buy-in for local strategies that you once had at a much higher level.
Relationships of trust are the absolute foundation of society in all times. That's what Transition and similar initiatives are about, and initiatives like this really can be successful even in very hard times.
So what about several friends pooling resources and starting a small business together-a business that provides goods or services that people need?
Pooling resources is great, but borrowing money is not. In a deflation, almost no money is changing hands, and therefore, you have almost no economy. At that point, if you have a business and have to service a debt, forget it-you're gone. Therefore, good preparation means borrowing no money at all.
Investing in skills is a very good idea. Being able to build and repair things is going to be an incredibly valuable skill. There's so much planned obsolescence in our economy that if someone can keep a washing machine designed to last only four years going for ten, they have a very valuable skill. Also, people setting up some kind of health clinic when healthcare is no longer available will be a phenomenally valuable service for their community.
For all of the systems that fail-systems that have been built from the top down, we must build parallel structures from the ground up. If we don't, when centralized systems start to fail, we have to provide parallel structures or we won't have them. Often, the provision of services is more valuable than the provision of goods.
We're going to get away from the idea of material wealth in general, so a lot of things that we currently regard as essential, we will come to understand are not.
What are some key areas in which people should prepare for the worsening collapse of industrial civilization?
Basically, people have to be prepared for our centralized life support systems beginning to fail. They don't fail all at once, but all these centralized systems that we provide from the top down are going to get less reliable. Not that they go away instantly, but they get rationed, or they are only available at certain times. Of course, we're not used to living that way, and for some people that will be catastrophic.
People could pool resources, get a little mini-van and set up their own local bus service with it. People will most certainly need to create their own food co-op's, and they can also create their own community renewable energy infrastructure. If the scale is kept local, people will accept it far more readily than structures that are beyond local scale and simply imposed on them. Community powered wells are also another possibility depending on the area of the world in which you reside. Different things will work in different places. Community water filters would be a great option if the water coming out of the tap is a little if-y-of course assuming that water is coming out of the tap.
People have to be creative and ask: What am I getting from the top down, and how else could I get that instead? This is being resilient.
Groups of teachers can get together and create a small community school when public education goes away or if and when it becomes a mandatory, government-managed system of indoctrination. Of course this depends on the particular community and if and how a government system operates there. Furthermore, a lot of people in rural areas are just not going to be able to get to schools as the busing system collapses.
We must be aware of the loss of political legitimacy which we are seeing right now in the U.S. elections. In some communities that are crumbling economically, there is little interest in politics at all. In fact, politics is perceived as a one-way street in which the government extracts tax revenues, and the community gets almost nothing in return. At that point, government becomes completely predatory.
Right now the government is completely between a rock and a hard place because in the worsening foreclosure debacle, if the government tells the people that it will not reinforce fraudulent mortgages against them, then the banks collapse, and the people are not happy about that. On the other hand, if the government comes down on the side of the banks, which they are more likely to do, and tells the people that fraudulent mortgages are going to be enforced against them, people are going to be furious. This has the potential to absolutely explode in the administration's face. There are no solutions to this.
This will be the number one culprit in public opinion for what's coming. What's coming was coming anyway, but the foreclosure mess will be seen as the cause. We are a rationalizing, not a rational, species. There are people right now who are very wealthy but may well be on the street and lose everything in a few years. Therefore, the elite are going to be much more elitist in the future. The insiders who know that you have to have liquidity are just sitting there with their cash waiting to buy everyone else's assets for pennies on the dollar. That lasts until people have nothing left to lose and then they get out the pitchforks, which at some point they will do.
So tell us about your tour of the U.S. that you're just now completing. How have you been received, and what is the mood among the people you have encountered?
This tour has been very successful, and I've done multiple tours before this in the U.S., and I've done two months in Europe. I drive, don't fly, and don't stay in hotels. The reception has been phenomenal. People have been really interested in hearing what I have to say, and they're very appreciative. It's providing them with the tools they need to navigate the future. I've never had a really skeptical audience.
Your future projects?
I'm thinking that I'll need at least a year for traveling. I'll be doing a conference in Michigan and then I'll be speaking at a biodiversity conference in Belgium, invited by the Belgian government. I'll be in England for a week and down the west coast of France and into Spain. I'll also be going to Germany to work with Transition Germany, and the National Bank of Poland called me up and wants me to go there. I keep my flying to a minimum because I don't like it, and I think we're going to see the kind of deterioration of air travel that we saw in the 70s. When people are in an unconstructed frame of mind, they cut corners, and when they don't have a lot of money and there's a lot of consolidation in the industry, that is a recipe for multiple disasters.
Thank you so much Nicole for your time and incredible insights. It sounds like you'll be back in Boulder in January, and I can't wait.
Chris Whalen: Obama's wearing Herbert Hoover's concrete booties
The Fed's $1 Trillion "Bazooka" Will Get Rolled Over The M-1 Tanks Of Deleveraging And Devaluation
by Charles Hugh Smith - Of two minds
Given that the economy faces $15 trillion in writedowns in collateral and credit, the Fed's $2 trillion dollars in new credit/liquidity is insufficient to trigger either inflation or another speculative bubble.
"Don't fight the Fed" is supposed to be a strong argument for being bullish on the U.S. economy and stocks. We all know the Federal Reserve is about to unleash a torrent of money into the financial markets via its QE2 (quantitative easing) campaign of buying Treasury bonds directly and pulling various other monetary levers to open the liquidity gates.
But before we succumb to the excitement that accompanies the unleashing of the Fed's supernatural powers, perhaps we should look at some numbers first.
Size of U.S. economy: $14 trillion. Probable size of QE2: $1 trillion. That means QE2 is perhaps 7% of GDP. Even a whopping $2 trillion QE would equal about 14% of GDP.
In contrast, by some measures China opened the floodgates of credit to the tune of fully 35% of their GDP to combat the contraction caused by the global financial meltdown in late 2008: China's Creative Accounting.
How much collateral and credit will be destroyed as the U.S. economy rolls over into recession/depression in 2011-14? Based on the latest (September 17, 2010) Fed Flow of Funds, here is my back-of-the-envelope estimates of losses yet to be booked in assets (collateral) and credit (debt):
1. Residential real estate: current value, $18.8 trillion. Estimated value in 2014: $13.8 trillion, i.e. a decline of $5 trillion or 26%. If all impaired mortgages are written down or sold for fair market value, I am guessing the full $5 trillion will need to be written off by somebody, somewhere.
My 26% estimate is conservative; according to the Case-Shiller Index chart, a decline of 40% would be required to return the index to the year-2000 level.
Image: Standard and Poor and Fiserv
2. Commercial real estate (CRE): The Flow of Funds only reports "nonfarm nonfinancial corporate business" so the CRE number of $6.5 trillion is a few trillion light (that is, we need to add in CRE owned by financial corporations). I am estimating writedowns of $3 trillion--a number others have also guesstimated.
Empty malls, empty office parks, empty warehouses, empty retail: they're all worth essentially zero. The cost of bulldozing them is higher than their auction value.
3. Consumer durable goods: All this "stuff" is supposedly worth $4.5 trillion, but when the millions of bulging storage units are emptied and sold, the actual market value of all this will be more like $3 trillion at best. So knock off another $1.5 trillion in collateral.
4. Corporate bonds: A huge steaming pile of junk bonds have been sold in the last year, bonds which will be four paws to the sky once inflated profits and corporate balance sheets adjust to the 2011-14 reality. Let's tag the losses here at $1 trillion, which is probably conservative.
5. U.S. stocks: Roughly $14 trillion: $6.7 trillion owned outright, $4 trillion in mutual funds and another $4 trillion in pension funds (which total about $11.6 trilion total). Once skyhigh estimates of future profits fall to Earth and the risk trade fades, then equities will get a $4 trillion haircut (i.e. they are about 30% overvalued).
Investors are already exiting equities as an asset class (once burned, twice shy, and they've been burned twice in 8 years) and the next downturn will accelerate this prudence:
6. Equity in noncorporate business: The Fed sets this at $6.6 trillion, and as the economy rolls over, households and business deleverage their massive debts and taxes rise, then a fair accounting of this non-publicly-traded equity would probably drop by at least $1 trillion.
I consider each of these estimates to be conservative, and they total $15 trillion. The Fed estimates total assets of households and nonprofits (which is of modest size compared to households) at $67 trillion, and net worth at $53 trillion (that is, liabilities are "only" $14 trillion).
A reduction in collateral of $15-$20 trillion (including the $3 trillion in CRE losses) would still leave tens of trillions in assets. But it would certainly impair the economy's ability to leverage up trillions more in new debt.
Rather, uncollectible, impaired or defaulted debt would have to be written down or written off. Those holding the debt--the "too big to fail" banks--would be bankrupted by these reductions in collateral.
This is an essential function of classic Capitalism--"creative destruction" and the disavowal of uncollectible or impaired debt.
So how do you generate the "modest inflation" which is the Fed's stated goal when $15 to $20 trillion in collateral and credit are disappearing from balance sheets? How do you goose credit enough to inflate a new asset bubble?
Well, I suppose you could create $15 trillion out of thin air and try to get households and businesses to borrow it, but that still wouldn't create the demand for goods and services which undergirds the real economy.
The Fed might make $15 trillion in new credit available and the only people wanting to borrow it are speculators within the Financial Power Elites who can rig the markets in their favor.
Gee, that sounds like the present. Did all that previous QE solve any of the economy's structural imbalances? No, it simply bathed balance sheets with the magic of "extend and pretend."
Excessive debt and speculative bubbles cannot be "fixed" with additional doses of debt and speculation. The Capitalist reality is this: if the Fed truly wanted to fix the U.S. economy rather than protect its over-extended, debt-ridden Financial System, then it would force the liquidation of trillions in bad debt and force a "marked to market" valuation on every balance sheet, household and corporate alike.
Instead, we have the "don't ask, don't tell" method of calculating asset values.
Anyone who believes a meager one or two trillion dollars in pump-priming can overcome $15-$20 trillion in overpriced assets and $10 trillion in uncollectible debt may well be disappointed.
The Fed's tinny little QE "bazooka" will be rolled over by the M-1 tanks of deleveraging and the recognition of $15-$20 trillion in losses.
The Q Ratio Indicates a Significantly Overvalued Market
by Doug Short - dshort.com
Note from dshort: The charts below have been updated based on the October monthly close of the Vanguard Total Market ETF, which I use for extrapolating the Q Ratio up to the present.
The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It's a fairly simple concept, but laborious to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. The data for making the calculation comes from the Federal Reserve Z.1 Flow of Funds Accounts of the United States, which is released quarterly for data that is already over two months old.
The first chart shows Q Ratio from 1900 through the first quarter of 2010. I've also extrapolated the ratio since June based on the price of VTI, the Vanguard Total Market ETF, to give a more up-to-date estimate.
Interpreting the Ratio
The data since 1945 is a simple calculation using data from the Federal Reserve Z.1 Statistical Release, section B.102., Balance Sheet and Reconciliation Tables for Nonfinancial Corporate Business. Specifically it is the ratio of Line 35 (Market Value) divided by Line 32 (Replacement Cost). It might seem logical that fair value would be a 1:1 ratio. But that has not historically been the case. The explanation, according to Smithers & Co. (more about them later) is that "the replacement cost of company assets is overstated. This is because the long-term real return on corporate equity, according to the published data, is only 4.8%, while the long-term real return to investors is around 6.0%. Over the long-term and in equilibrium, the two must be the same."
The average (arithmetic mean) Q ratio is about 0.70. In the chart below I've adjusted the Q Ratio to an arithmetic mean of 1 (i.e., divided the ratio data points by the average). This gives a more intuitive sense to the numbers. For example, the all-time Q Ratio high at the peak of the Tech Bubble was 1.82 — which suggests that the market price was 158% above the historic average of replacement cost. The all-time lows in 1921, 1932 and 1982 were around 0.30, which is 57% below replacement cost. That's quite a range.
Another Means to an End
Smithers & Co., an investment firm in London, incorporates the Q Ratio in their analysis. In fact, CEO Andrew Smithers and economist Stephen Wright of the University of London coauthored a book on the Q Ratio, Valuing Wall Street. They prefer the geometric mean for standardizing the ratio, which has the effect of weighting the numbers toward the mean. The chart below is adjusted to the geometric mean, which, based on the same data as the two charts above, is 0.65. This analysis makes the Tech Bubble an even more dramatic outlier at 179% above the (geometric) mean.
The More Complicated Calculation of Tobin's Q
John Mihaljevic, who was Dr. Tobin's research assistant at Yale and collaborated with Tobin in revising the ratio formula, uses a more complex formula based on the Flow of Funds data for calculating Q. The formula is explained in detail at Mihaljevic's Manual of Ideas website. The chart below uses the Mihaljevic/Tobin formula for the Q calculation.
I would make two points about the more intricate formula. First it produces results that are remarkably similar to the simple calculation (first chart above. Also, the chart here differs somewhat from the version posted at the Manual of Ideas website (reproduced here), even though my chart uses the Manual of Ideas calculation formula. I've corresponded with John about the differences, and he explained them as an artifact of undocumented revisions to the government's Flow of Funds data. The Manual of Ideas Q Ratio is updated quarterly when the latest Z.1 numbers are released, and no changes are made to the ratio for previous quarters. My charts were built from scratch with the historic Z.1 data with any undocumented revisions included.
Note: My calculations with the last two Z.1 releases confirm John's explanation of undocumented Fed tinkering with the older data. The changes are relatively minor, but they have resulted in over a dozen quarterly Q modifications ranging from -0.01 to +0.02, with the upward adjustments clustered toward the recent quarters.
Unfortunately, the Q Ratio isn't a very timely metric. The Flow of Funds data is over two months old when it's released, and three months will pass before the next release. To address this problem, I've been making extrapolations for the more recent months based on changes in the market value of the VTI, the Vanguard Total Market ETF, which essentially becomes a surrogate for line 32 in the data. The last two Z.1 releases have validated this approach. The extrapolated ratios for July through October are 0.97, 0.92, 1.00 and 1.04.
Bottom Line: The Message of Q
The mean-adjusted charts above indicate that the market remains significantly overvalued by historical standards — by about 48% in the arithmetic-adjusted version and 60% in the geometric-adjusted version. Of course periods of over- and under-valuation can last for many years at a time.
Please see the companion article Three Market Valuation Indicators that features overlays of the Q Ratio, the P/E10 and the regression to trend in US Stocks since 1900. There we can see the extent to which these three indicators corroborate one another.
Note: For readers unfamiliar with the S&P Composite index, see this article for some background information.
Fed Risks Its Credibility on a Bowlful of Mush
by Caroline Baum - Bloomberg
It's all over but the voting.
After all the speeches and the posturing, after the trial balloons and the press leaks, the Federal Reserve probably will announce another round of quantitative easing at the conclusion of its two-day meeting Wednesday. The Fed embarks on this program with the intention of lowering yields on long-term Treasuries, which in turn will bring down mortgage rates and corporate bond yields. Surely there must be two or three households holding back on a home purchase because the 30-year mortgage rate at 4.2 percent is too onerous.
If QE1, which entailed the purchase of $1.4 trillion of agency debt and mortgage-backed securities (in addition to $300 billion of Treasuries), was about credit easing, QE2 then is about prices. I have yet to hear any Fed official talk about Q, about increasing the quantity of money -- specifically bank reserves -- which is where quantitative easing gets both its name and its heft.
Either the Fed is operating under a misconception about how QE2 will reduce unemployment and raise inflation, or it has failed to communicate the transmission mechanism to the public. Neither is a plus. About the best thing anyone can say about the well- advertised and anticipated QE2 is that it won't do much good. The worst thing is that it will inflate asset prices, which we don't call inflation.
Because Fed chief Ben Bernanke has been unwilling to admit the role low interest rates played in puffing up the housing bubble, he sees little risk from further easing, according to Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. At the same time, he says, the Fed's output gap models, which measure the difference between actual and potential growth and were "violently wrong in 2003 and 2004," reinforce the majority view that deflation is the real threat.
Then there's the Fed's stated tactic of raising inflation expectations to lower real interest rates, a flawed concept even though it has succeeded splendidly in the short term. In the two months since Bernanke first hinted at QE2 in his Jackson Hole, Wyoming, speech, five-year inflation expectations five years from now, the Fed's preferred measure extrapolated from the yield differential between nominal and inflation- indexed Treasuries, have risen from about 2 percent to 3 percent.
So taken is the Fed with the notion that higher inflation expectations are the route to salvation that it has commissioned research on the subject. Last month, three Fed Board economists published a paper claiming that with overnight rates near zero, an oil price shock would be a plus for growth.
The "burst of inflation" from an increase in oil prices stimulates interest-rate sensitive sectors of the economy, the authors claim. (Aren't higher oil prices a relative price increase unless the Fed prevents other prices from falling?) "In fact, if the increase in oil prices is gradual, the persistent rise in inflation can cause a GDP expansion," they write. Where are the speculators when you need them?
Ten years ago I wrote a column titled, "Fed Chairman Ali Naimi Has a Nice Ring to It," referring to Saudi Arabia's oil minister. The piece debunked the idea that oil prices can do the central bank's job. Maybe I was wrong. If you believe the research, we should be rooting for one of those old-fashioned oil shocks, circa 1973 and 1979, to fix what ails the U.S. economy!
Raising inflation expectations to lower real long-term rates has two flaws. First, it assumes nominal rates don't move. (The nominal rate consists of a real rate plus a premium for expected inflation.) Nominal rates could easily rise in sync with inflation expectations, leaving real rates unchanged. The second reason has to do with the Fed's credibility: real, expected and long-term. "Credibility against deflation is tied to credibility against inflation," says Marvin Goodfriend, professor of economics at Carnegie Mellon University's Tepper School of Business in Pittsburgh.
What Goodfriend means is, the Fed has "the independence and operational capacity" to fight inflation and deflation via its control over bank reserves. What it doesn't have is the luxury of overshooting to fight deflation, producing more inflation in the short run, when expectations have been manipulated higher. (While I agree with blogger Mish Shedlock that inflation expectations are "elegant nonsense," I'm using the Fed's framework to critique its logic.)
'Late in Coming'
Almost two years have elapsed since the central bank pushed the funds rate to near zero. In that time, policy makers have failed to explain the framework for fighting deflation, Goodfriend says. Without that framework, it has to take risks with policy. "The action is premature; the framework is late in coming," he says of QE2. It would be better to stabilize inflation expectations in the 1 percent to 2 percent range, the Fed's implicit target since 1996, and provide a coherent framework for understanding how its actions affect the economy and prices.
Under Bernanke, monetary policy has become enamored with the idea that "communication and expectations adjustment is where all the leverage is," says Timothy Duy, director of the Oregon Economics Forum at the University of Oregon in Eugene. If the Fed has failed to communicate its framework for fighting deflation, as Goodfriend says, and if expectations aren't your cup of tea, no wonder you're nervous. Bernanke is headed into uncharted waters with no compass, no radar, and no stars to guide him.
The good news is he's got plenty of fuel. The bad news: His only rations are gruel.
Captain Bernanke on course for icebergs
by Edward Chancellor - Financial Times
This week Ben Bernanke is likely to announce a new programme of “large-scale asset purchases”. The aim of quantitative easing is to dispel deflation and reduce unemployment. Yet the plan is beset with controversy. It’s not clear whether it will have much effect on the real economy or whether the Federal Reserve chairman has fully considered the long-term consequences of his unconventional policy. Investors have already bid up asset prices in anticipation of the central bank’s move. But the financial gains from quantitative easing are a fool’s gold.
It is generally agreed that a bout of quantitative easing in 2008 succeeded in calming the markets. But conditions are different today. The credit system is not dislocated and banks are willing to lend, according to the Fed’s survey of senior loan officers. The problem is not with the supply of credit but with lacklustre demand from the private sector. Any new money created by the central bank expanding its balance sheet may well end up adding to the existing pile of more than $1,000bn of excess reserves in the banking system.
Quantitative easing is also intended to reduce unemployment, which remains at very elevated levels. But much of the current unemployment may be structural in nature. People who can’t find a job because they are in the wrong place with the wrong skills won’t find their prospects improved by the central bank acquiring Treasury bonds. Nor will lower rates help many consumers. After the recent decline in house prices, about half of US homeowners find themselves owing more than their homes are worth and are thus unable to refinance. And since long-term rates in the US are already so low, quantitative easing is unlikely to promote much new business investment.
Mr Bernanke is tilting at windmills. Not only is deflation absent in the US, it is arguable whether mild deflation is economically damaging. And even if it were, no one knows whether asset purchases by the central bank could succeed in reversing a deflationary tide. After the great credit binge, deflation reflects the desire of households and companies to pay down their excessive debts. It is a symptom, not a cause, of a problem. The experience of Japan over recent decades shows that deleveraging does not end because long-term rates decline. This explains why the Bank of Japan believes quantitative easing is futile.
Mr Bernanke hopes that by boosting asset prices, consumers will spend more. But as Tim Lee of Pi Economics points out, this implies a further decline in saving at a time when the country’s net savings rate is negative. The US needs to save and invest more to ensure its long-term prosperity. Quantitative easing threatens to postpone the necessary rebalancing of the US economy.
The fiscal consequences of quantitative easing are also troubling. The financial crisis has put the nation’s finances in disarray. The 2010 US fiscal deficit will be about 9 per cent of GDP. With the Fed ready to monetise a great chunk of the government’s spending, there is even less chance that Washington will exercise fiscal discipline.
Quantitative easing involves the manipulation of household balance sheets by the central bank. As a result, asset prices are distorted and bubbles are inflated (as GMO’s Jeremy Grantham explains in his latest Quarterly Letter*). Over recent months the markets have anticipated QE2 by rushing indiscriminately into risky assets. Valuations have become extended. At current levels, US equities offer poor future returns and Treasury bonds are very overvalued. The Fed may succeed in distorting asset prices in the short run, but it cannot do so indefinitely. People who have been misled into spending more today because of a temporary improvement to their balance sheets will have to retrench at some future date.
The international consequences of quantitative easing are also deleterious. Over the past couple of months the dollar has weakened as liquidity has flowed towards the higher-yielding currencies in emerging markets. The recipients of unwanted capital inflows have been forced to buy dollars to prevent their currencies appreciating. But foreign exchange interventions serve to loosen domestic monetary conditions in emerging markets, producing inflation and asset price bubbles. This explains why several countries, including South Korea, are considering the introduction of capital controls.
In recent months, brokers have eagerly anticipated the launch of QE2. Their clients have been enjoined with nautical metaphors to “ride the liquidity wave”. But they have identified the wrong ship and the wrong location for the cruise. Rather than steering towards balmy waters, Captain Bernanke has set course towards the iceberg fields. Full speed ahead!
Federal Reserve's, Bernanke's credibility on line with new move to boost economy
by Neil Irwin - Washington Post
The Federal Reserve is preparing to put its credibility on the line as it rarely has before by taking dramatic new action this week to try jolting the economy out of its slumber.
If the efforts succeed, they could finally help bring down the stubbornly high jobless rate. But should the Fed overshoot in its plan to pump hundreds of billions of dollars into the economy, it could produce the same kind of bubbles in the housing and stock markets that caused the slowdown. Or the efforts could fall short and fail to energize the economy, leaving a clear impression that the mighty Fed is out of bullets - thus adding even more anxiety to an already dire situation.
The meeting of Fed policymakers Tuesday and Wednesday is set to be a defining moment of Ben S. Bernanke's second term as chairman of the central bank. Although he helped win the war against the great financial panic of 2008 and 2009, he now risks losing the peace if he fails to end the protracted economic downturn that followed.
Just two years after the world financial system nearly collapsed, it is again gut-check time for Bernanke. "The greatest risk for the Fed in taking this action is that it could extend the economy's funk by giving a sense that either no one is in charge or that the people who are in charge can't get it right," said David Shulman, senior economist at the UCLA Anderson Forecast. "The whole psychology of that could leak back into the economy."
Jobs and prices
The Fed is charged by Congress with a twin mandate of maintaining maximum employment and stable prices, and it is failing on both counts. The economy isn't in free fall. But as new data on gross domestic product affirmed Friday, the economy is mired in mediocre growth, too slow to bring down the unemployment rate. Inflation, meanwhile, is running about 1 percent, below the rate Fed officials view as optimal. When inflation is a little higher, it encourages consumers and businesses to spend money before it loses value.
"Viewed through the lens of the Federal Reserve's dual mandate," William C. Dudley, the New York Fed president, said in a speech early last month, ". . . the current situation is wholly unsatisfactory." When Bernanke was confirmed earlier this year for a second four-year term, the widespread assumption was that his major task would be to decide when and how to move away from the unconventional measures taken during the crisis to boost growth.
In reducing its target for short-term interest rates to zero, the Fed had exhausted its normal tool for managing the economy. So the central bank pumped money into the economy by buying vast quantities of bonds - more than $1.7 trillion worth. Now the Bernanke Fed is poised, if not to double down on that earlier bet, at least to up its wager.
"Phase one was to avoid a complete market meltdown and something akin to the Great Depression," said Mark Gertler, a New York University economist who has collaborated with Bernanke on academic research. "Phase two begins now and is in some ways trickier. . . . Once again we're in a situation where we have to use policies we haven't really experimented with."
The Fed is seeking to avoid the fate of Japan, where falling prices and weak economic growth over the past two decades have created a self-reinforcing economic stagnation. The hope is that by moving aggressively, such a cycle can be averted. Fed watchers expect that the two days of meetings around a giant mahogany table will culminate this week in the announcement of around $500 billion in Treasury bond purchases and perhaps a statement indicating a willingness to make even more.
The intended benefits are already being felt. In anticipation of the Fed's action, investors have driven down mortgage rates, creating an extra incentive for people to buy a home. Expectations have also driven the stock market up, making Americans feel wealthier. And the dollar has fallen in value, making U.S. exporters more competitive, as currency investors reacted to an expected decline in U.S. interest rates.
But there's a danger that the bond purchases could work too well. For example, while a modest decline in the dollar could be good for the economy, a steep and disorderly drop could be disastrous. And while Fed leaders want the inflation rate to be higher than it is now, if prices were to accelerate rapidly, that would be unwelcome.
There's also a risk that investors could view the Fed's program of buying Treasury bonds as a signal that the central bank essentially plans to fund U.S. budget deficits indefinitely by printing money. That could prompt interest rates to rise, stymieing the economic recovery.
Thomas M. Hoenig, president of the Kansas City Fed, appears likely to dissent from the Fed's decision this week. He said in October that such measures "could be a very dangerous gamble," given the risk of stoking asset bubbles, for instance in the stock market. If, on the other hand, the efforts to jump-start growth fall flat, the Fed would be confronted with an even knottier quandary: take even bolder steps, such as a trillion-dollar round of bond purchases, or admit that these kinds of measures won't work and stand pat.
Ultimately, the question of whether the Fed can invigorate the economy depends on whether companies, individuals and even the government respond to lower interest rates by spending and investing. Rates have been at exceptionally low levels for more than a year and corporate America is in sound shape financially, yet companies are holding back on hiring more employees and making new investments. Executives say they lack confidence that consumers will boost demand for products, because Americans are busy paying down debts.
Some economists argue that the volume of bond purchases needed to jar the economy into motion again is vastly larger than what the Fed has seriously considered. Larry Meyer, a former Fed governor now with Macroeconomic Advisers, estimated last week that it would take more than $5 trillion worth, 10 times what analysts are expecting. Fed leaders deem such gargantuan numbers too risky.
Either way, if the Fed overshoots or falls short, it could undermine the faith of the public and the financial markets in the ability of the government to address prolonged high unemployment and the risk of falling prices.
At a time when investors are already skittish about gridlock in Washington, such doubts could spook financial markets, creating a self-reinforcing downward cycle in the economy. (By contrast, the U.S. economy flourished from the mid-1980s until 2008 in part because investors and businesses were confident that the Fed would keep the nation on a steady growth path.)
A failed effort by the Fed could also prompt renewed calls to limit its authority and independence at a moment when popular discontent over its role in bailing out the financial system has already made the central bank a target for many in Congress. But some partisans of the Fed are urging it take dramatic new steps even if there's a chance they don't work.
"I think the public understands that if unemployment remains high, monetary policy isn't going to be the reason," said Victor Li, a Villanova professor and former Fed economist. "No one is going to say the Fed isn't doing everything it can.
Fed poised for biggest decision in decades
by Robin Harding - Financial Times
This week’s meeting of the US Federal Reserve’s monetary policy committee will be one of the most important in decades as it prepares to launch a new round of quantitative easing. It will not be a “saving the world on a Sunday night” occasion like the meetings during the financial crisis, but that only adds to its historical significance. The world’s most important central bank is about to use quantitative easing as a routine instrument of monetary policy for the first time.
The goal of QE2 – the nickname for this new round of easing – is to push down long-term interest rates by buying long-term Treasury bonds. On its success rests both the reputation of Ben Bernanke, the Fed chairman, and the chances that the US economy can avoid a decade of weak growth. At this week’s meeting, on Tuesday and Wednesday, the Fed’s rate-setting open market committee will assess just how badly it expects to miss its dual mandate of maximum employment and stable prices.
Each FOMC member will update economic forecasts for 2011 and 2012 and make a prediction for 2013 as well. The 2013 forecasts are vital to the case for action. They are likely to show that inflation will remain below the Fed’s 2 per cent objective in three years’ time and that unemployment will still be above the rate the Fed thinks is achievable in the long run.
“Given the committee’s objectives, there would appear, all else being equal, to be a case for further action,” as Mr Bernanke put it in a recent speech in Boston. That case is unlikely to be derailed despite opposition from some on the FOMC who feel that the risks of QE2 are too great. Thomas Hoenig, president of the Kansas City Fed, has said that looser policy is a “dangerous gamble” and is certain to vote against. Three other non-voting members are definite opponents, while several more have reservations.
Mr Bernanke is likely to carry the day, but the question is how decisive the Fed is willing to be. David Semmens, US economist at Standard Chartered in New York, speaks for many in the markets when he says: “I think a key is that the programme is aggressive and confidence inspiring.” Rather than a huge programme of asset purchases all announced up front, the Fed has made clear that it wants QE2 to evolve in size depending on the economic data. But it is still likely to make a downpayment by pledging at least some asset purchases on Wednesday: $500bn is a likely figure for this initial round of buying.
It will also set a buying speed. The Fed already has to buy $30bn of Treasuries a month in order to reinvest early repayments from its portfolio of mortgage-backed securities, so it is unlikely to want to buy more than a further $80bn-$100bn a month. If the initial figure were $500bn, it could therefore pledge to buy them over the next two quarters. Far more important, however, is what the Fed says about further purchases once the initial round is complete. “I think what the market is looking for is a firm commitment to monetary easing going forward and without that they will be very disappointed,” said Mr Semmens.
The Fed has put intense effort into judging what it should signal and how. The FOMC has at least three broad options. First, it could be neutral, pledging to adjust the size of QE2 depending on the data. Second, it could signal a clear bias towards continuing to buy assets unless the economic data have improved. Third, it could pledge to keep buying assets until it is on track to achieve its inflation objective.
Option three is the strongest because it gives an open-ended commitment to keep expanding the size of QE2 until the economy improves. This guidance – and not the headline figure for asset purchases – is what will move markets most on Wednesday. But there is also the chance of a surprise. Fed staff were still working on options as the committee went into “blackout” last week. On a decision this momentous, for the Fed, the US and the world economy, the meeting may take on a life of its own.
Federal Reserve to unleash QE2 and fund the US deficit in coming months
by Michael Hennigan - Finfacts
The Federal Reserve will conclude a two-day meeting of its rate setting Federal Open Market Committee (FOMC) on Wednesday and it's expected to unleash its latest program of quantitative easing -- nicknamed QE2 - - which is effectively money printing to boost the flagging recovery and raise inflation. The central bank is expected to buy about $100bn of bonds from the market between future FOMC meetings which is in line with the expected US budget deficit. In effect, the Fed will be absorbing from the market most of the new bonds issued by the Treasury during the timeframe of the new program.
The Fed already has $1.7trn of assets on its balance sheet that it bought during the financial crisis of 2008 and 2009. This is more than the annual GDP of the United States and FOMC member - - Thomas Hoenig, the president of the Kansas City Fed -- recently said looser policy is a "dangerous gamble," while Charles Evans, president of the Chicago Fed, said "in my opinion, much more policy accommodation is appropriate today," because "the US economy is best described as being in a bona fide liquidity trap" - - a situation where ultra-low interest rates and high savings rates conspire to neuter monetary policy.
Market speculation is that the Fed will announce $500bn of asset purchases spread over about six months. It is likely to give itself some flexibility to reduce the amount if the economic recovery accelerates during the period.
Joachim Fels, a managing director at US investment bank, Morgan Stanley, based in London, says there are three debates around QE2:
First, how effective will the additional large-scale bond purchases that the FOMC looks likely to announce be in attaining the Fed's two stated goals: raising inflation, (which according to Chairman Bernanke at around 1% is too low) and lowering unemployment, which at close to 10% is too high?
Second, how does a more expansionary US policy stance alter the balance of risks to growth, inflation and asset prices in emerging market economies?
And third, will central banks in Europe follow the Fed in easing policy further, or will monetary policy paths start to diverge?
While ultimately the jury remains out on all three questions, Fels says recent events provide some interesting clues.
How Much Traction for the Fed?
A measured, flexible buying program...Joachim Fels says Morgan Stanley's (MS) Fed watcher David Greenlaw notes, a pace of buying of around $100bn per intermeeting period, which could be scaled up or down at future meetings, "would be roughly in line with our estimated budget deficit ($1.15trn) for fiscal 2011. So, the Fed would be absorbing virtually all of the net new Treasury issuance as long as it maintained this pace of purchases."
...that has already had major effects.Fels saysthe Fed has already been hugely successful in kick-starting important elements in the transmission mechanism from additional bond purchases to the real economy and inflation before the programme has even started, namely asset prices and inflation expectations. Since Chairman Bernanke first hinted at additional stimulus in late August, US equities have rallied by more than 10%, real yields on inflation-linked 10-year government bonds have dropped by half a percentage point, the dollar has depreciated by 6% on a trade-weighted basis, and 10-year breakeven inflation rates have risen by 65bp.
But will the economy respond? He says higher equity prices and lower real interest rates should support corporate investment spending, a weaker dollar should stimulate exports, and rising inflation expectations coupled with lower interest rates should induce consumers to consume today rather than tomorrow. Yet, with the various well-known headwinds - - such as renewed weakness in the housing market, consumer deleveraging, the mortgage put-back situation, and corporates' inclination to hoard cash - - MS say there is good reason to believe that the benefits to the economy from renewed asset purchases will be limited. Against this backdrop, it seems reasonable to assume that the Fed's new purchase programme will be kept in place for a long time and may be increased in the event that growth and inflation don't respond sufficiently over time.
Also watch M1 to judge success: Fels says apart from the usual economic indicators that everybody is watching to gauge the success of QE2, MS says focus should be on the development in the amount of cash and overnight deposits (the monetary aggregate M1) held by non-banks as an indication of whether QE2 will be working or not. To the extent that the Fed's additional bond purchases lower interest rates along the yield curve, households and corporates would be incentivised to hold more cash as the opportunity cost of holding non-interest bearing assets declines. Also, if banks become more willing to extend credit (or purchase assets), either because rising asset prices bolster their own and non-banks' balance sheets or because they view the higher excess reserves that are created through QE2 as excessive, this would show up in higher deposits and thus M1 (as extending a loan means creating a deposit).
The economist says US M1 has risen substantially over the past several years. The level of M1 is now almost 30% higher (or 9.4% annualised) than at the start of 2008 when the recession began. Thus, the Fed has prevented the collapse in the money stock that played a leading role in the 1930s deflation. Three factors have contributed to the strong rise in M1 over the past three years: first, higher precautionary cash holdings by corporates and households; second, lower interest rates; and third, the Fed's asset purchases which have not only bloated banks' excess reserves but, to some extent, also non-banks' cash holdings. While the growth rate of M1 has slowed from a peak rate of 18%Y in mid-2009 to 7.3%Y in September, it has reaccelerated in recent months from a trough of 4%Y in July.
Rising Tail Risks Outside of the US
David Kotok, chairman and chief investment officer at Cumberland Advisors, gives his take on how much the Fed's QE2 will likely amount to. He tells CNBC's Martin Soong, Sri Jegarajah and Karen Tso, that any announcement less than $500 billion will disappoint markets:
QExport... Importantly, the expectation of more monetary easing in the US has already had important ramifications outside the US, most notably in EM. Commodity prices have risen, many EM currencies, especially in Asia, have appreciated versus the dollar, and the EM equity rally that was already underway since the early summer gained speed since Ben Bernanke started to hint at QE2 in late August. Some central banks, such as the Bank of Korea, have already slowed or aborted rate hikes in order to offset the tightening monetary conditions that have come through exchange rate appreciation.
...raises risk of trade wars, global inflation and asset bubbles: Fels says while the Fed's additional bond purchases are welcome because they should help to minimise the tail risk of deflation for the US, the combination of Fed easing, downward pressure on the dollar and the various policy responses by other countries increase the risk of undesirable outcomes elsewhere. One such risk is rising protectionism: any trade war would have negative consequences for the global economy. Another is the risk of asset bubbles in commodities and emerging markets with potential inflationary or, once these bubbles burst, deflationary consequences.
"The ECB is more concerned about inflationary pressures... while the Fed is turning toward more stimulus," Julia Coronado, chief economist North America at BNP Paribas, told CNBC Friday:
US-Europe Policy Divergence?
While additional monetary easing in the US seems to be a done deal, the odds in Europe are against further monetary stimulus, at least for now.
UK economic backdrop different from US: In the UK, earlier expectations for QE2 following the issue of the Bank of England's Monetary Policy Committee (MPC) minutes were quashed last week by significantly stronger-than-expected 3Q GDP growth, which makes it unlikely that the MPC will embark on more asset purchases in November. With UK real GDP having grown at a higher-than-expected average annualised pace of 4% in the two middle quarters of this year (1.2% and 0.8% on the quarter in non-annualised terms in 2Q and 3Q, respectively) and inflation significantly above target and expected to remain there for an extended period, the UK economic backdrop is very different from the current one in the US. This may change into 2011, when MS economists expect growth to slow sharply as the fiscal tightening kicks in, but for now it looks unlikely that the Bank of England will follow the Fed anytime soon.
ECB still in phasing-out mood.Joachim Fels says recent economic data in the Eurozone have also surprised on the upside, with especially Germany and France continuing to show strong momentum in the recent business surveys. Consequently, some ECB council members have indicated that the staff forecasts in December look likely to be revised up. Against this backdrop, the ECB's game plan still seems to be to gradually phase out the remaining 'unconventional' measures - - unlimited liquidity provisions to the banks at the regular tenders and selective, small-scale purchases of peripheral government bonds - - over the medium term.
The ECB looks even less likely than the Bank of England to follow the Fed into additional monetary easing.
But what if the euro surges? Yet how would the ECB respond if the euro would rise further against the dollar as the Fed embarks on additional asset purchases?
Fels says the first thing to note is that the ECB usually looks at the euro against a broad basket of currencies. On the ECB's nominal effective exchange rate index, the euro is up 6% from its early summer low, but it stands slightly below its moving five-year average, and even almost 10% below the peak late last year. Thus, the euro would have to rise a lot further to get the ECB seriously worried.
Second, the ECB has a deep-rooted aversion against embarking on large-scale purchases of government bonds. Even though there are no legal obstacles as long as the bonds are purchased in the secondary market, the ECB is worried about blurring the distinction between monetary and fiscal policy and the potential political pressures that could result if the ECB owned a large portfolio of government bonds. Thus, rather than purchasing large amounts of government bonds, the ECB would probably resort to other tools first. One such tool would be a cut in the refi rate. Another would be sterilised or even unsterilised currency intervention. However, both are only remote possibilities at this stage.
The euro as Ersatzgold? Joachim Fels says it is not at all obvious that the ECB would really use these tools to resist a major appreciation of the euro, if it happened. If (a big if) this appreciation occurred because the US was seen by markets as actively trying to debase its currency in an attempt to avoid deflation and recession, the ECB might well choose to offer investors who flee from the reserve currency a new home. True, the price to pay for becoming a reserve currency is a significant loss in external competitiveness and a current account deficit reflecting the capital inflows. Yet, the benefits of offering investors a form of Ersatzgold would include higher asset prices and permanently lower interest rates, which would help especially highly indebted governments.
Fraud Caused the 1930s Depression and the Current Financial Crisis
by George Washington - Washington's Blog
Robert Shiller - one of the top housing experts in the United States - says that the mortgage fraud is a lot like the fraud which occurred during the Great Depression. As Fortune notes:Shiller said the danger of foreclosuregate -- the scandal in which ithas come to light that the biggest banks have routinely mishandled homeownership documents, putting the legality of foreclosuresand related sales in doubt -- is a replay of the 1930s, when Americanslost faith that institutions such as business and government weredealing fairly.
The former chief accountant of the S.E.C., Lynn Turner, told the New York Times that fraud helped cause the Great Depression:The amount of gimmickry and outright fraud dwarfs any period since the early 1970's, when major accounting scams like Equity Funding surfaced, and the 1920's, when rampant fraud helped cause the crash of 1929 andled to the creation of the S.E.C.
Economist Robert Kuttner writes:In 1932 through 1934 the Senate Banking Committee, led by its ChiefCounsel Ferdinand Pecora, ferreted out the deeper fraud and corruptionthat led to the Crash of 1929 and the Great Depression.
Similarly, Tom Borgers refers to:The 1930s’ Pecora Commission, which investigated the fraud that led to the Great Depression ....
Professor William K. Black writes:The original Pecora investigation documented the causes of the economic collapse that led to the Great Depression. It ... established that conflicts of interest and fraud were common among elite finance and government officials.
The Pecora investigations provided the factual basis that produced a consensus that the financial system and political allies were corrupt.
Moreover, the Glass Steagall Act was passed because of the fraudulentuse of normal bank deposits for speculative invesments. As theCongressional Research Service notes:In the Great Depression after 1929, Congress examined the mixing of the “commercial” and “investment” banking industries that occurred in the 1920s. Hearings revealed conflicts of interest and fraud in some banking institutions’ securities activities. A formidable barrier to the mixing of these activities was then set up by the Glass Steagall Act.
Economist James K. Galbraith wrote in the introduction to his father, John Kenneth Galbraith's, definitive study of the Great Depression, The Great Crash, 1929:
The main relevance of The Great Crash, 1929 to the great crisis of 2008 is surely here. In both cases, the government knew what it should do. Both times, it declined to do it. In the summer of 1929 a few stern words from on high, a rise in the discount rate, a tough investigation into the pyramid schemes of the day, and the house of cards on Wall Street would have tumbled before its fall destroyed the whole economy. In 2004, the FBI warned publicly of "an epidemic of mortgage fraud."But the government did nothing, and less than nothing, delivering instead low interest rates, deregulation and clear signals that laws would not be enforced. The signals were notsubtle: on one occasion the director of the Office of Thrift Supervision came to a conference with copies of the Federal Register and a chainsaw. There followed every manner of scheme to fleece the unsuspecting ....
This was fraud, perpetrated in the first instance by the government on the population, and by the rich on the poor.
The government that permits this to happen is complicit in a vast crime.
As the Great Crash, 1929 documents, there were many fraudulent schemes which occurred in the 1920s and which helped cause the Great Depression.Here's one example of a pyramid scheme in Florida real estate:An enterprising Bostonian, Mr. Charles Ponzi, developed a subdivision “near Jacksonville.”It was approximately sixty-five miles west of the city. (In other respects Ponzi believed in good, compact neighborhoods ;he sold twenty-three lots to the acre.) In instances where the subdivision was close to town, as in the case of Manhattan Estates, which were “not more than three fourths of a mile from the prosperous and fast-growing city of Nettie,” the city, as was so of Nettie, did not exist. The congestion of traffic into the state became so severe that in the autumn of 1925 the railroads were forced to proclaim an embargo on less essential freight, which included building materials for developing the subdivisions. Values rose wonderfully. Within forty miles of Miami “inside” lots sold at from $8,000 to $20,000; waterfront lots brought from $15,000 to $25,000, and more or less bona fide seashore sites brought $20,000 to $75,000.”
As DoctorHousingBubble notes:This Mr. Ponzi of course is the man who gave name to the “Ponzi scheme” that many use today. He laid the groundwork for many of the criminals today in the housing industry. Yet during the boom he wasn’t seen as a criminal but a player in the Florida real estate bubble. Here’s a nice picture of the gentleman:
James Galbraith recently said that "at the root of the crisis we find the largest financial swindle in world history", where "counterfeit" mortgages were "laundered" by the banks.
As he has repeatedly noted, the economy will not recover until the perpetrators of the frauds which caused our current economic crisisare held accountable, so that trust can be restored. See this, this and this.
No wonder James Galbraith has said economists should move into the background, and "criminologists to the forefront."
Note 1:I asked Professor Black to comment on this essay, and he said the following:
The amount of fraud that drove the Wall Street bubble and its collapse and caused the Great Depression is contested [keep reading to see what Black means]. The Pecora investigation found widespread manipulation of earnings, conflicts of interest, and insider abuse by the nation's most elite financial leaders. John Kenneth Galbraith's work documented these abuses. Theoclassical economic accounts, however, ignore or excuse these abuses. The Justice Department did not respond effectively to the crimes that helped spark the Great Depression so we have far fewer facts available to us.The decisive role that "accounting control frauds" played in driving the current crisis is clear. The FBI warned of an "epidemic" of mortgage fraud in 2004 and predicted that it would cause an economic crisis if it were not stopped. The mortgage lending industry's own experts reported that "liar's" loans were "an open invitation to fraudsters" and fully warranted their name -- "liar's" loans -- because fraud was endemic in such loans. Lenders and their agents led these lies. They led the lies for an excellent reason -- the strategy is a "sure thing" (Akerlof & Romer 1993 -- Looting: the Economic Underworld of Bankruptcy for Profit). It guarantees record (albeit fictional) profits, which maximize the CEO's bonuses. The same strategy for maxmizing fictional income maxmizes real losses in the longer term. When many lenders follow the same fraudulent strategy the result is a hyper-inflated bubble followed by a severe crisis.
Control fraud epidemics also produce "echo" epidemics of fraud in other fields. For example, when lenders are control frauds the CEO establishes perverse incentives ("Gresham's dynamics") that corrupt other industries and professions.
By rewarding professionals who are willing to inflate asset values, and refusing to hire honest professionals, control frauds cause the unethical to drive the ethical out of the markets. When one combines deregulation, desupervision, and the perverse incentives of modern executive and professional compensation the result is recurrent, intensifying crises.
Note 3: Of course other factors, such as excess leverage and counterproductive actions by theFederal Reserve, also contributed to the 1930s Depression and the current crisis.
Angela Merkel consigns Ireland, Portugal and Spain to their fate
by Ambrose Evans-Pritchard - Telegraph
Germany has had enough. Any eurozone state that spends its way into a debt crisis or cannot adapt to a monetary union set for Northern rhythms will face “orderly” bankruptcy. Bondholders will discover burden-sharing. Debt relief will be enforced, either by interest holidays or haircuts on the value of the bonds. Investors will pay the price for failing to grasp the mechanical and obvious point that currency unions do not eliminate risk: they switch it from exchange risk to default risk. What were investors thinking when they bought Greek 10-year bonds at 26 basis points over Bunds in 2007, below the spread between British Columbia and Quebec?
“We must keep in mind the feelings of our people, who have a justified desire to see that private investors are also on the hook, and not just taxpayers,” said German Chancellor Angela Merkel. Or in the words of Bundesbank chief Axel Weber: “Next time there is a problem, (bondholders) should be part of the solution rather than part of the problem. So far the only ones who have paid for the solution are the taxpayers.”
These were the terms imposed by Germany at Friday’s EU summit as the Quid Pro Quo for the creation of a permanent rescue fund in 2013. A treaty change will be rammed through under Article 48 of the Lisbon Treaty, a trick that circumvents the need for full ratification. Eurosceptics can feel vindicated in warning that this “escalator” clause would soon be exploited for unchecked treaty-creep. Mrs Merkel needs a treaty change to prevent the German constitutional court from blocking the bail-out fund as a breach of EU law, and a treaty change is what she will get. “This will strengthen my position with the Karlsruhe court,” she admitted openly.
One might argue that bondholders should have been punished for their errors long ago. The stench of moral hazard has been sickening, on both sides of the Atlantic. An orderly bankruptcy along lines routinely engineered by the International Monetary Fund is exactly what Greece needs. It makes no sense to push Greece further into a debt compound spiral by raising public debt from 115pc of GDP at the outset of the “rescue” to 150pc at the end of the ordeal.
If you strip out the humbug, the Greek package allows banks and funds to shift roughly €150bn of liabilities onto EU governments, or the European Central Bank, or the IMF. Greek citizens are being subjected to the full pain of austerity under false pretences, without being offered the cure of debt relief. It is in reality a bail-out for investors. There is a touch of cruelty in this. Needless to say, the Greek Left has noticed. A socialist dissident from the “anti-Memorandum” bloc (ie anti EU-IMF) is likely to win the Athens region in coming elections.
Note too that the ruling socialists have fallen to 25pc in the Portuguese polls, while the Communists and hard-left Bloco are together up to 18pc. Ain’t seen nothing, you might say.
Yet opening the door to bondholder haircuts at this delicate juncture – with spreads reaching fresh records in Ireland last week, and Portugal struggling to pass a budget – is to toss a hand-grenade into the eurozone periphery.
We now know that that ECB’s Jean-Claude Trichet warned EU leaders on Thursday night that it was dangerous to stir up this hornets’ nest, and moreover that the politicians did not understand what they were unleashing. He was slammed down acrimoniously by French President Nicolas Sarkozy, who later denied that he lost his temper.
“Mr Trichet expressed a number of reserves. There was a debate, there is always a debate, but the European Council took its decision,” he said. “It is wrong to say I was irritated. You can reproach heads of state for all kinds of things in a democracy, but I don’t think you can reproach them for not being aware of the seriousness of the situation,” he snorted.
Mr Sarkozy was not going to let his Brussels `triomphe’ slip away after stitching up EU affairs once again in a pre-emptive deal with Germany and imposing his will. The notion that the Franco-German axis still runs Europe is potent politics in France, even if the decisions actually reached are often of little value or – as in this case – ill-advised. Such is the chemistry of EU summits, where mad things happen. Spain’s premier Jose-Luis Zapatero knew he had been mugged. “We need to listen carefully to what the head of the ECB says about the rescue mechanism. Great care is called for because this message is risky,” he said.
Eurozone sovereign states must issue €915bn in new bonds next year, according the UBS, either to roll over debt or to cover very big deficits – though it is hard to outdo Ireland’s deficit of 32pc of GDP in 2009. Yet investors have just been told in blunt terms to charge a hefty risk premium on any peripheral debt that expires after 2013, with great confusion over what happens even before that date. Can any investor be sure what the terms will be if Ireland or Portugal needs to access the EU’s bail-out fund next week, or next month, or next year? Are haircuts already de rigueur?
A study by Giada Giani at Citigroup entitled 'Bondholders Moving Back Home' said data from the second quarter reveals a sharp drop in foreign ownership of debt from Greece (-14pc), Portugal (-12pc), Spain (-8pc), and Ireland (-5pc). Local banks have stepped into the breach, borrowing cheaply from the ECB to buy their own state debt at higher yields in a `carry trade’ that concentrates risk. These four countries account for the lion’s share of the €448bn in ECB funding for banks (Spain €98bn, Greece €94bn). Frankfurt is propping up this unstable edifice. Mr Trichet may well fret.
A strong case can be made that Spain has decoupled from other PIGS in pain, though the deficit will still be 6pc next year, and the economy is at serious risk of a double-dip recession as wage cuts and higher taxes bite in earnest. But none are safe yet. An ominous pattern has emerged across much of the eurozone periphery: tax revenue keeps falling short of what was hoped. Austerity measures are eating deeper into the economy than expected, forcing further fiscal cuts. It goes too far to call this a self-feeding spiral, but such policies test political patience to snapping point.
There is little that these nations can do in the short-run as EMU members. They cannot offset fiscal tightening with full monetary stimulus or a weaker exchange rate – as Britain can. All they do can is soldier on, sell family silver to the Chinese and Gulf Arabs, beg the ECB to join the currency war to bring down the euro, and pray that the fragile global recovery does not sputter out.
Chancellor Merkel is ultimately correct. A mechanism for sovereign defaults is entirely healthy. Had it been in place long ago, EMU would have been stronger. The proper timing for this was at the Maastricht Treaty, or Amsterdam, or at the latest Nice, but in those days the EU elites were still arrogantly dismissive about the implications of a currency union. To wait until now borders on careless.
Home prices expected to slide another 8%
by Les Christie - CNNMoney.com
The robo-signing controversy is just another issue that the already sluggish housing market didn't need -- but most analysts do not think it will have far-reaching impact. Nevertheless, the housing market still faces many problems: a weak economy, sluggish hiring, tight mortgage underwriting, falling home prices, and slowing sales.
Then there's the potentially disastrous number of foreclosures that may occur over the coming years. "The market faces much bigger problems than the robo-signing issue," said Mike Larson, a housing market analyst for Weiss Research. Prime among them are declines in home prices. And while cheaper homes are good for buyers, they also speak to a housing market that won't stabilize.
Fiserv, a market analytics company, has scaled back its home price projections considerably. In February, it forecast national price gains of about 4% through the end of 2011. The company's latest prediction is for a 7.1% drop in prices between June 30, 2010 and June 30, 2011. In fact, after five months of gains, prices in the 20 largest metro areas fell 0.2% in August, according to the latest S&P/Case-Shiller report.
The good news is, "There'll be no vicious, self-reinforcing spiral down," according to Mark Zandi, chief economist with Moody's Analytics. But, he added, "more home price declines are coming." He's forecasting another 8% drop in home prices through the third quarter of 2011, which will put the total peak-to-trough decline at 34%. Even after that, in 2012, he sees very little price growth.
Home prices continue to fall because sales aren't taking off. Without buyers, the market can't bottom out. New home sales continue to languish around historic lows, barely exceeding an annual rate of 307,000. Existing home sales did rise to a 4.53 million annualized rate in September, up 10% compared with a month earlier, but are still well below the boom years. Of course, nobody is buying homes when they can't find jobs. And still more people can't hang on to their homes because they're out of work.
Nearly a million homes are expected to be repossessed this year, and analysts seem to be competing to issue the most dire forecast for future foreclosure numbers.
- Morgan Stanley reported that about 3.1 million borrowers are seriously delinquent with many expected to lose their homes.
- Zandi said more than 4 million are in trouble with half of those expected to go to foreclosure.
- And Laurie Goodman, of Amherst Securities, estimates the number of homes in danger of foreclosure at a whopping 11 million.
- Real estate analyst Kyle Lundstedt of LPS Applied Analytics said serious delinquencies will continue to spike and will not return even to the current rates -- which are already at peak levels -- until late 2012 or early 2013.
"The housing market is very fragile," said Goodman.
However, Zandi sees a few factors that are positive. These include: Low interest rates; FHA, Fannie Mae and Freddie Mac all lending to qualified buyers; and an improving job picture. Zandi is especially confident that the employment picture is about to brighten. Corporate profits have spiked and, historically, hiring follow profits -- with a lag of eight to 10 months. That means companies should start hiring workers very soon, Zandi said.
And once Americans start returning to work, they'll find home prices are very reasonable. Housing is the most affordable it's been since the pre-boom years. During the boom, Zandi said, prices were overvalued by about 50%; today it's close to zero. That has attracted many investors, including foreign buyers. They've been scooping up single-family-homes and condos in hard-hit markets like Florida, the Southwest and the Midwest and renting them out.
"The reason they're in these markets is because they see value," said Zandi. But, he added, "If they see the robo-signing issue continue, they could begin to exit the market. If they do, there could be more price declines. That's one reason why a foreclosure moratorium could be destructive."
America's Recovery Has Now Exposed The Fact That A Large Chunk Of American Consumers Don't Even Matter
by Vincent Fernando - Business Insider
Yesterday, we learned from the BEA how consumer spending has made a full recovery, with real personal consumption expenditures (PCE) in September hitting its highest level since the crisis began. A chart of this from Carpe Diem is shown below.
Meanwhile, the U.S. economy has almost fully recovered, even in real GDP terms, as shown below. A few more periods of growth and U.S. GDP will be making record highs again.
However, oddly, joblessness remains extremely high, with the unemployment rate at 9.6% in September -- the same month that showed the full recovery for consumer spending above.
Huge swathes of Americans are still struggling to meet their basic needs, are stretched by debt, or sit on large unrealized housing losses. The U.S. poverty rate recently hit a 15-year high.
Negative facts such as these have caused skeptics, since early 2009, to think a U.S. recovery was impossible. Look at unemployment, look at housing, look at the poverty rate... they're all still horrible.
But here's a thought -- What if a large chunk of American consumers don't really matter? Then, the entire situation is far less perplexing, and in fact, it turns out that the richest 5% of America accounts for a massive 37% of all consumer spending according to North Carolina State University. That's gargantuan, and maybe is the reason why many recovery skeptics have been proven so wrong ever since mid-2009. Yes tons of Americans are still in horrible shape, but they are, sadly, just a drop in the economic bucket relative to their ultra rich compatriots.
For better or worse, that's at least how the economics of America appear.
China's Creative Accounting: Using Debt as an Instrument of Economic Development
by Ellen Brown - Web of Debt
China may be as heavily in debt as we are. It just has a different way of keeping its books -- which makes a high-profile political ad sponsored by Citizens Against Government Waste, a fiscally conservative think tank, particularly ironic. Set in a lecture hall in China in 2030, the controversial ad shows a Chinese professor lecturing on the fall of empires: Greece, Rome, Great Britain, the United States . . . .
"They all make the same mistakes," he says. "Turning their backs on the principles that made them great. America tried to spend and tax itself out of a great recession. Enormous so-called stimulus spending, massive changes to health care, government takeover of private industries, and crushing debt."
Of course, he says, because the Chinese owned the debt, they are now masters of the Americans. The students laugh. The ad concludes, "You can change the future. You have to."
James Fallows, writing in the Atlantic, remarks:“The ad has the Chinese official saying that America collapsed because, in the midst of a recession, it relied on (a) government stimulus spending, (b) big changes in its health care systems, and (c) public intervention in major industries -- all of which of course, have been crucial parts of China's (successful) anti-recession policy.”
That is one anomaly. Another is that China has managed to keep its debt remarkably low despite decades of massive government spending. According to the IMF, China’s cumulative gross debt is only about 22% of 2010 GDP, compared to a U.S. gross debt that is 94% of 2010 GDP.
What is China’s secret? According to financial commentator Jim Jubak, it may just be “creative accounting” -- the sort of accounting for which Wall Street is notorious, in which debts are swept off the books and turned into “assets.” China is able to pull this off because it does not owe its debts to foreign creditors. The banks doing the funding are state-owned, and the state can write off its own debts.
“China has a history of taking debt off its books and burying it, which should prompt us to poke and prod its numbers. If we go back to the last time China cooked the national books big time, during the Asian currency crisis of 1997, we can get an idea of where its debt might be hidden now.”
The majority of bank loans, says Jubak, went to state-owned companies -- about 70% of the total. The collapse of China’s export trade following the crisis meant that its banks were suddenly sitting on billions in debts that were clearly never going to be paid. But that was when China’s largest banks were trying to raise capital by selling stock in Hong Kong and New York, and no bank could go public with that much bad debt on its books.
The creative solution? The Beijing government set up special-purpose asset management companies for the four largest state-owned banks, the equivalent of the “special purpose vehicles” designed by Wall Street to funnel real estate loans off U.S. bank books. The Chinese entities ultimately bought $287 billion in bad loans from state-owned banks. To pay for the loans, they issued bonds to the banks, on which they paid interest. The state-owned banks thus got $287 billion in toxic debt off their books and turned the bad loans into an income stream from the bonds.
Sound familiar? Wall Street did the same thing in the 2008 bailout, with the U.S. government underwriting the deal. The difference was that China’s largest banks were owned by the government, so the government rather than a private banking cartel got the benefit of the arrangement. According to British economist Samah El-Shahat, writing in Al Jazeera in August 2009:“China hasn’t allowed its banking sector to become so powerful, so influential, and so big that it can call the shots or highjack the bailout. In simple terms, the government preferred to answer to its people and put their interests first before that of any vested interest or group. And that is why Chinese banks are lending to the people and their businesses in record numbers.”
In the US and UK, by contrast:“[B]anks have captured all the money from the taxpayers and the cheap money from quantitative easing from central banks. They are using it to shore up, and clean up their balance sheets rather than lend it to the people. The money has been hijacked by the banks, and our governments are doing absolutely nothing about that. In fact, they have been complicit in allowing this to happen.”
Today, Jubak continues, China's debt problem is the thousands of investment companies set up by local governments to borrow money from banks and lend it to local companies, a policy that has produced thousands of jobs but has left an off-balance-sheet debt overhang. He cites economist Victor Shih, who says local-government investment companies had a total of $1.7 trillion in outstanding debt at the end of 2009, or about 35% of China's GDP. Banks have extended $1.9 trillion in credit lines to local investment companies on top of that. Collectively, the debt plus the credit lines come to $3.8 trillion. That is about 75% of China's GDP, which is proportionately quite a bit smaller than U.S. GDP. None of this is included in the IMF’s calculation of a gross-debt-to-GDP figure of 22%, says Shih. If it were, the number would be closer to 100% of GDP.
Proportionately, then, China may be more heavily in debt than we are. Yet it is still managing to invest heavily in infrastructure, local businesses and local jobs. Its creative accounting scheme seems to be working for the Chinese. It may be sleight of hand, but it was a necessary ploy to harmonize their economic realities with Western banking standards.
For China to join the World Trade Organization in 2001, it had to revise its accounting methods to conform to Western requirements; but before it joined, it did not consider grants to its state-owned enterprises to be “non-performing loans.” They were what the IMF calls “contingent grants.” If they paid off, great; if they didn’t, they were written off. There were no creditors demanding payment from the state-owned banks. The creditor was the state; and the state, at least in theory, was the people. In any case, the state owned the banks. It was lending to itself, and it could write off its loans at will. It was better to sweep the “NPLs” into “SPVs” than to cut back on services and impose heavier taxes on the people. The Chinese government did cut back on services and raise taxes, to the detriment of the struggling masses, but not to the extent that would otherwise have been necessary to balance their books by Western standards.
While the rest of the world suffers from an unrelenting credit crunch, today China’s banks are on a lending binge. The rush to make new loans is a direct response to the government’s economic stimulus policy, which emphasizes infrastructure and internal development. The Chinese government was able to get its banks to open their lending windows when U.S. banks were being tight-fisted with their funds, because the government owns the banks. The Chinese banking system has been partially privatized, but the government is still the controlling shareholder of the Big Four commercial banks, which were split off from the People’s Bank of China in the 1980s.
We might take a lesson from the Chinese and put our own banks to work for the people, rather than making the people work for the banks. We need to get our dollars out of Wall Street and back on Main Street, and we can do that only by breaking up Wall Street’s out-of-control private banking monopoly and returning control over money and credit to the people themselves.
We could also take a lesson from the Chinese and dispose of our debt with a little creative accounting: when the bonds come due, we could pay them with dollars issued by the Treasury, in the same way that the Federal Reserve has issued Federal Reserve Notes to save Wall Street with its “Quantitative Easing” program. The mechanics of that process were revealed in a remarkable segment on National Public Radio on August 26, 2010, describing how a team of Fed employees bought $1.25 trillion in mortgage bonds beginning in late 2008. According to NPR:"The Fed was able to spend so much money so quickly because it has a unique power: It can create money out of thin air, whenever it decides to do so. So . . . the mortgage team would decide to buy a bond, they'd push a button on the computer – ‘and voila, money is created.’”
If the Fed can do it to save the banks, the Treasury can do it to save the taxpayers. In a paper presented at the American Monetary Institute in September 2010, Prof. Kaoru Yamaguchi showed with sophisticated mathematical models that if done right, paying off the federal debt with debt-free Treasury notes would have a beneficial stimulatory effect on the economy without inflating prices.
The CAGW ad is correct: we have turned our backs on the principles that made us great. But those principles are not rooted in “fiscal austerity.” The abundance that made the American colonies great stemmed from a monetary system in which the government had the power to issue its own money – unlike today, when the only money the government issues are coins. Dollar bills are issued by the Federal Reserve, a privately owned central bank; and the government has to borrow them like everyone else. But as Thomas Edison famously said:“If the Nation can issue a dollar bond it can issue a dollar bill. The element that makes the bond good makes the bill good also. The difference between the bond and the bill is that the bond lets the money broker collect twice the amount of the bond and an additional 20%. . . . It is a terrible situation when the Government, to insure the National Wealth, must go in debt and submit to ruinous interest charges at the hands of men who control the fictitious value of gold."
China’s government can direct its banks to advance credit in the national currency as needed, because it owns the banks. Ironically, the Chinese evidently got that idea from us. Sun Yat-sen was a great admirer of Abraham Lincoln, who avoided a crippling national debt by issuing debt-free Treasury notes during the Civil War; and Lincoln was following the lead of the American colonists, our forebears. We need to reclaim our sovereign right to fund the common wealth without getting entangled in debt to foreign creditors, through the use of our own government-issued currency and publicly-owned banks.
107 Months to Clear Banks’ Housing Backlog
by Mark Whitehouse - Wall Street Journal
107: How many months it would take to sell banks’ current and shadow inventory of foreclosed homes.
Banks’ vast pile of foreclosed homes doesn’t appear to be diminishing. That’s a troubling sign for the future of the housing market. Back in April, this column tallied up all the foreclosed homes sitting in banks’ inventory, as well as the “shadow” inventory of homes in the foreclosure process or on which owners had missed at least two mortgage payments. At the time, we reported that at the current rate of sales, it would take 103 months to unload it all.
Over the past six months, that number has actually risen. Banks managed to pare down the shadow inventory, but largely by taking possession of foreclosed homes. As of September, they owned nearly 994,000 foreclosed homes, up 21% from a year earlier. The shadow inventory stood at 5.2 million homes, down 7% from a year earlier. Grand total: 107 months of inventory.
The numbers aren’t exactly comparable to the April analysis, as the providers of data have changed. The inventory data now come from RealtyTrac, the shadow inventory data from LPS Applied Analytics, and the sales data from Core Logic. But no matter how you slice it, the housing market faces almost nine years of foreclosure hangover.
Over the summer, banks appeared to be making some headway. The government’s mortgage-modification program helped some people get current on their payments, taking their homes out of the foreclosure pipeline. At the same time, homebuyer tax credits helped boost sales. Combined real and shadow inventory fell to 91 months of sales in May.
Lately, though, a new wave of defaults appears to be coming in, in part related to the high rate of failures on government modifications. As of September, some 1.9 million homeowners had missed one payment on their mortgages, up 14% from March. Meanwhile, home sales have slowed sharply with the end of government stimulus.
Homeowners might reasonably hope that banks’ latest troubles with foreclosure paperwork might prop up prices by at least temporarily easing the flow of homes onto the market. So far, though, that doesn’t seem to be happening: According to housing-market consultancy Zelman & Associates, banks listed 15% more repossessed home in October than in September. The mountain of foreclosed homes casts a long shadow.
Robert Shiller Sees More Housing Pain Ahead
by Jennifer Schonberger - Kiplinger's Personal Finance
When it comes to calling bubbles, Yale professor Robert Shiller has a pretty good track record. He raised a red flag about Internet stocks just before the market crashed in 2000, and he called the housing bubble in 2006 -- again, just before prices tumbled. Now the co-creator of the S&P/Case-Shiller Home Price index says the foreclosure crisis is another chapter in the story of mistrust of financial institutions that was ushered in with the financial crisis and the recession. And with so little confidence in the housing market, he says, prices have further to fall. In an interview with Kiplinger, Shiller shares his views on how foreclosure-gate could lead to another bailout, why the housing market won’t recover in 2011, and why he sees a good chance of a double-dip recession.
KIPLINGER: How much of an issue is the foreclosure fiasco for the recovery of the housing market and the economy? Does this go beyond a paper-processing problem?
SHILLER: It’s another hit to our public sense of trust and confidence in our financial institutions. Business relies on trust, and if you can’t trust anyone, you can’t do business very well. That’s a very different kind of confidence than is measured by the standard indices. But I think it’s very important for the economy.
How much of an effect will foreclosure-gate have on home prices?
Home prices were declining for almost three years, from 2006 to 2009. Then they picked up remarkably. But the pickup corresponded to the home-buyer’s tax credit. So it doesn’t look as if there’s a clear indication of change in home-buyer sentiment. The latest S&P/Case-Shiller data shows that home prices are flat again. Based on those numbers, I would be concerned about the possibility of a longer-term decline in home prices. I think this is more important than foreclosure-gate. If home prices drop further, homeowners will fall further underwater and lending institutions’ balance sheets will become more distressed. That could bring on another phase of the crisis.
So you aren’t optimistic that home prices will recover in 2011?
My company, MacroMarkets, does a survey of professional forecasters, and the survey has been weakening in recent months. We ask them to forecast as far out as 2014. On average, they’re now predicting a cumulative home-price increase of about 8% from today out to 2014, or about 2% a year. That’s a modest recovery. If their forecast turns out to be right, that might be enough to propel the construction industry out of the extreme doldrums. But it doesn’t seem like it’s enough to bring back a vibrant market.
You might think that it’s about time for the housing market to recover because it’s been at historically low levels in terms of new construction for quite some time now. But it’s not showing signs of that yet. So I think there’s a good chance that we’ll have a weak housing market next year. Unfortunately, there’s a good chance we’ll see declining prices over the next year.
What if banks end up having to buy back bad mortgages? How will this affect the financial system?
Well, they might need another bailout. The problem is that public opinion was kind of negative about bailouts. I think it’s fortunate that both political parties were involved with the TARP bailouts. So it’s not a partisan issue, I hope.
Do you think Congress should intervene to help fix the housing market?
They should take some action. The fact that so many people are in foreclosure is a national tragedy. In the future, we should build mortgages with built-in workouts [mortgages that allow greater flexibility to avoid foreclosure by adjusting payments when the borrower is experiencing financial hardship]. Our failure to do workouts this time was a colossal error. We should be thinking about other kinds of mortgages that are not so vulnerable to this kind of crisis. We created a situation that caused a recession that wiped out the net worth of about 15 million households. That’s a mistake. Many of these people have virtually no other savings. So there was something wrong with the system.
Do you still maintain the view that there is more than a 50% chance that the U.S. slips back into recession?
I still stand by the view that there’s more than a 50% chance we’ll slip back into a recession before we recover from this one -- before unemployment is back down to a normal level. I don’t know that it will be in 2011. I just think that the unemployment rate is going to stay high for a long time, and recessions come with some regularity. The economy is not looking particularly strong now, so it could come soon.
Suicide Is Painless
by Jim Quinn - Burning Platform
Everyone has watched one of the best TV series of all-time – M*A*S*H. You also know the tune that played during the opening credits as helicopters delivered wounded soldiers to the 4077 Mobile Army Surgical Unit. Most people have never heard the lyrics that go with the music. The song is Suicide is Painless and the lyrics were sung during the M*A*S*H Movie. As I watched the movie a few weeks ago, the lyrics struck home. Our country has been slowly committing suicide for the last 40 years. The movie and TV series were set during the Korean War. It is fitting that military spending is one of the major causes of our suicide as a nation. On an inflation adjusted basis, the US has doubled spending on Defense since 1962. It is on course to rise another 20% in the next four years. Dwight D. Eisenhower warned us about the military industrial complex in 1961:
“In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military industrial complex. The potential for the disastrous rise of misplaced power exists and will persist.”
The fact that the US currently spends 7 times as much on Defense as the next nearest country is proof that the military industrial complex has gained unwarranted influence and a disastrous rise of misplaced power has occurred.
U.S. DEFENSE SPENDING
When you critically analyze why we would need to spend 7 times as much as China on military when there is no country on earth that can challenge us, the answer can only be OIL. Our own military came to the following chilling conclusion in their Joint Operating Environment report, issued earlier this year:
By 2012, surplus oil production capacity could entirely disappear, and as early as 2015, the shortfall in output could reach nearly 10 MBD.
A severe energy crunch is inevitable without a massive expansion of production and refining capacity. While it is difficult to predict precisely what economic, political, and strategic effects such a shortfall might produce, it surely would reduce the prospects for growth in both the developing and developed worlds. Such an economic slowdown would exacerbate other unresolved tensions, push fragile and failing states further down the path toward collapse, and perhaps have serious economic impact on both China and India. At best, it would lead to periods of harsh economic adjustment. To what extent conservation measures, investments in alternative energy production, and efforts to expand petroleum production from tar sands and shale would mitigate such a period of adjustment is difficult to predict. One should not forget that the Great Depression spawned a number of totalitarian regimes that sought economic prosperity for their nations by ruthless conquest.
The U.S. military knows we are on the verge of an oil crisis. There are no new supplies ready to come on line before 2015. The President and his advisors know that an oil crisis is in our immediate future. We have military bases in Saudi Arabia, Iraq, and Kuwait. We have active fighting forces in Afghanistan and Pakistan. We have a naval armada of aircraft carriers in the Persian Gulf. Our forces completely encircle Iran. Is this a coincidence when the countries with the largest oil reserves in the world are noted?
- Saudi Arabia – 262 billion barrels
- Iran – 133 billion barrels
- Iraq – 112 billion barrels
- Kuwait – 97 billion barrels
The war on terror is a cover for access to the hundreds of billions of barrels of oil in the Middle East. A 10 million barrel per day shortfall by 2015 would be disastrous for a country that consumes 25% of all the oil in the world. Our hyper-consumer society is like a drug addict, dependent on its oil fix. If we are denied oil for even one day, the withdrawal symptoms would be traumatic and harrowing.
There are 255 million passenger vehicles in the U.S. Our society will collapse within weeks without a sufficient supply of oil. The average American’s only concern about oil is when they get a card in the mail from Jiffy Lube telling them it is time for their 5,000 mile oil change. They stick a hose in their gas tank and fluid pours out, allowing them to motor freely around mall dotted suburbia. Within five years they will be paying over $5 per gallon for this fluid or they will be waiting in lines for three hours to get 10 gallons of that precious fluid. Peak cheap oil has been predictable for decades. The Department of Energy was created 31 years ago. Preparing for peak cheap oil would have required some pain, sacrifice and forethought. But, suicide is painless.
Visions of Things To Be
Through early morning fog I see
visions of the things to be
the pains that are withheld for me
I realize and I can see…
That suicide is painless
It brings on many changes
and I can take or leave it if I please.
Suicide is Painless – M.A.S.H. Movie
As I peer through the fog and attempt to see visions of things to be, I see nothing but pain ahead. Anyone who can look at the following chart and not conclude that there is much pain ahead for this country is either a Goldman Sachs banker, a Federal Reserve Governor, or a bought off politician in Washington DC. It is no coincidence that after Richard Nixon closed the gold window in 1971 and allowed the Federal Reserve to “manage” our economy that total debt outstanding in the US surged from $2 trillion to over $50 trillion. GDP has risen by 1,300% since 1971, while total US debt has risen by 2,600%. Now for the kicker. Real GDP has only gone up by 292% since 1971. This means that 1,000% of the increase in GDP was from Federal Reserve created inflation. Over this same time frame, real wages have declined by 6%, from $318 per week in 1971 to $299 per week today. Inflation has been the American drug of choice to commit suicide over the last 40 years. It is stealthy, seemingly painless, and deadly.
Inflation is the “painless” method through which the Federal Reserve has decided this country will commit suicide. It is like turning on the car in the garage and letting the carbon monoxide slowly put you to sleep. The ruling elite are content that the American public is dumbed down by the government run public schools. They count on the fact that 9 out of 10 Americans do not understand inflation. It is an insidious scheme of robbing the working middle class and funneling it to the Wall Street/K Street ruling class. The Federal Reserve has gotten bolder in the last few years as they realized the public doesn’t understand or care what they do. Bernanke has relished in the mainstream media adulation that he saved the world with his printing press in 2008/2009. Even though critical thinkers know for a fact that it was Federal Reserve policies that created the worldwide financial conflagration in the first place, the corporate mainstream media and the Wall Street beneficiaries have been cheerleaders of Easy Al and Helicopter Ben. These men are traitors. They have purposefully impoverished senior citizens and the working middle class in order to enrich their ruling elite masters on Wall Street and in Washington DC.
Ben Bernanke on Wednesday afternoon will announce Quantitative Easing Part Deux. This is a fancy name for Ben printing $1 trillion out of thin air, buying US Treasuries and/or more toxic mortgage securities and artificially lowering interest rates to convince Americans to spend money they don’t have. Jeremy Grantham, in his recent quarterly letter, issues a scathing indictment of Bernanke’s methods:
“For all of us, unfortunately, there is still a further great disadvantage attached to the Fed Manipulated Prices. When rates are artificially low, income is moved away from savers, or holders of government and other debt, toward borrowers. Today, this means less income for retirees and near-retirees with conservative portfolios, and more profit opportunities for the financial industry; hedge funds can leverage cheaply and banks can borrow from the government and lend out at higher prices or even, perish the thought, pay out higher bonuses. This is the problem: there are more retirees and near retirees now than ever before, and they tend to consume all of their investment income. With artificially low rates, their consumption really drops. The offsetting benefits, mainly shown in dramatically recovered financial profits despite low levels of economic activity, flow to a considerable degree to rich individuals with much lower propensities to consume."
The ruling elite in Washington DC and Wall Street decided that fraud, misinformation and cooking the books was preferable to the pain of honesty, orderly bankruptcy, and assets valued at their true worth. Ben Bernanke ”saved the world” by putting the taxpayer on the hook for $1.5 trillion of toxic mortgage garbage he bought from his masters on Wall Street. John Hussman describes the decision to choose painless suicide over choosing painful medicine to cure our disease:
“Over the short run, two policies have been primarily responsible for successfully kicking the can down the road following the recent financial crisis. The first was the suppression of fair and accurate financial disclosure – specifically FASB suspension of mark-to-market rules – which has allowed financial companies to present balance sheets that are detached from any need to reflect the actual liquidating value of their assets. The second was the de facto grant of the government’s full faith and credit to Fannie Mae and Freddie Mac securities. Now, since standing behind insolvent debt in order to make it whole is strictly an act of fiscal policy, one would think that under the Constitution, it would have been subject to Congressional debate and democratic process. But the Bernanke Fed evidently views democracy as a clumsy extravagance, and so, the Fed accumulated $1.5 trillion in the debt obligations of these insolvent agencies, which effectively forces the public to make those obligations whole, without any actual need for public input on the matter.”
The Only Way to Win is Cheat
The only way to win is cheat
And lay it down before I’m beat
and to another give my seat
for that’s the only painless feat.
That suicide is painless
It brings on many changes
and I can take or leave it if I please.
Suicide is Painless – M.A.S.H. Movie
The Federal Reserve has incessantly created new bubbles every time one of their old bubbles has burst, since the elevation of Alan Greenspan as Fed Chairman in 1987. The bailout of LTCM convinced Wall Street that uncle Al would come to the rescue if their gambles endangered the financial system. Greenspan cheered on the internet revolution and flooded the system for the fake Y2K crisis. When the internet bubble burst in 2000 and the 9/11 attack struck in 2001, Greenspan aided and abetted the greatest bubble in history. He dropped interest rates to historic lows, encouraged the use of adjustable rate mortgages, didn’t enforce bank regulations, and pretended that he couldn’t see the bubble forming. Jeremy Grantham explained the Federal Reserve, Wall Street and K Street conspiracy to avoid the pain of dealing with our long-term structural problems in his latest letter:
“House prices may often not be susceptible to manipulation. Low interest rates may not be enough: they may stimulate hedge fund managers to speculate in stocks, but most ordinary homeowners are not interested in speculating. To stir up enough speculators to move house prices, we needed a series of changes, starting with increasing the percentage of the population that could buy a house. This took ingenuity on two fronts: overstating income and reducing down payment requirements, ideally to nil. This took extremely sloppy loan standards and virtually no data verification. This, in turn, took a warped incentive program that offered great rewards for quantity rather than quality, and a corporation overeager, with aggressive accounting, to book profits immediately. It also needed a much larger, and therefore new, market in which to place these low-grade mortgages. This took ingenious new packages and tranches that made checking the details nearly impossible, even if one wanted to. It took, critically, the Fed Manipulated Prices to drive global rates down. Even more importantly, it needed the global risk premium for everything to hit world record low levels so that suddenly formerly staid European, and even Asian, institutions were reaching for risk to get a few basis points more interest. Such an environment is possible only if there exists an institution with a truly global reach and a commitment to drive asset prices up. In the U.S. Fed, under the Greenspan-Bernanke regime, just such an institution was ready and willing.”
On Wednesday Ben Bernanke will inject more poison into the veins of a once great country. This country, at one time, dealt with its problems in a realistic manner and was willing to sacrifice, cooperate, and make hard choices. QE2 will not help our economy or solve any of our problems.
Is It To Be Or Not To Be?
A brave man once requested me
to answer questions that are key
‘is it to be or not to be’
and I replied ‘oh why ask me?’
‘Cause suicide is painless
it brings on many changes
and I can take or leave it if I please.
…and you can do the same thing if you choose.
Suicide is Painless – M.A.S.H. Movie
The leaders of this country, with the full support of a zombie like disinterested distracted electorate, have chosen to ignore and defer every tough decision regarding energy, spending, entitlements, deficits, and infrastructure. The Federal Reserve has allowed politicians to run the National Debt up to $13.6 Trillion by imposing no limits on the printing of fiat currency backed by nothing but promises. Based on Obama’s 10 year budget projections, adjusted for the real impact of Obamacare and extension of Bush tax cuts, the National Debt will reach $20 trillion in 2015 and $25 trillion by 2019. This is truly a suicide mission. We will never reach these levels because the sweet relief of death will overtake our economic system as the final vestiges of QE2 painlessly bring about the end.
Grantham warns that Bernanke’s actions on Wednesday are a desperate last ditch attempt to fend off the pain of reality. It will fail.
“Thus, our current policy of QE2 is merely the last desperate step of an ineffective plan to stimulate the economy through higher asset prices regardless of any future costs. Continuing QE2 may be an original way of redoing the damage done by the old Smoot-Hawley Tariff hikes of 1930, which helped accelerate a drastic global decline in trade. We may not even need the efforts of some of our dopier Senators to recreate a more traditional tariff war. And all of this stems from the Fed and the failed idea that it can or should interfere with employment levels by interfering with asset prices.”
The only difference between Dr. Bernanke and Dr. Kevorkian is that Kevorkian helped the terminally ill commit suicide. Dr. Bernanke and his colleagues at the Federal Reserve have inflicted suicide on a patient that was healthy and capable of living many more years. The suicide concoction of fiat currency, debt, military empire, and delusion has been painless for those in power, but painful for the working middle class of this country. Dr. Bernanke fancies himself as an expert on the Great Depression. He is destined to be remembered as the man who killed America. Suicide is painless, it brings on many changes.
WaMu path clearer to bankruptcy exit
by Tom Hals - Reuters
Shares of Washington Mutual Inc fell 60 percent on Tuesday after a court-appointed examiner extinguished hopes that stockholders would recover anything in the two-year-old bankruptcy. The examiner's report, issued late Monday, backed the company's finding that there is no money to pay shareholders anything. The report was seen as generally positive for bondholders, who gain some certainty that the company will exit bankruptcy and repay them in the coming months.
Washington Mutual filed for bankruptcy in September 2008 after its lending operation was seized by regulators in the biggest bank failure in U.S. history. Shareholders have accused regulators of jumping the gun. After the seizure, the bank was sold immediately to JPMorgan Chase & Co for $1.9 billion.
The bankruptcy wiped out individual investors who held the common stock. Shareholders won a victory earlier this year when a U.S. Bankruptcy Court judge in Delaware appointed an examiner to investigate their claims. But the examiner, in his report, determined there was likely little to be gained from tearing up a settlement among Washington Mutual, the Federal Deposit Insurance Corp and JPMorgan.
The three parties agreed to drop competing legal claims and to divide billions of dollars of disputed cash and tax refunds. Most creditors will be paid in full under the company's proposed reorganization. "The bulk of the holding company bankruptcy case is coming into focus in terms of outcomes," said Kevin Starke, an analyst with CRT Capital Group in Stamford, Connecticut.
The examiner's report was good news for noteholders who are first in line to be paid, Starke said. The company can emerge from bankruptcy as soon as the end of the year, he added. The company's common stock was down 64.2 percent at 5.75 cents in late-morning pink sheets trade, with more than 70 million shares changing hands. Two issues of preferred stock were both down 70 percent.
"I think it was a little shocking but I don't think this is done yet," said Larry Amboy, a shareholder based in California. The examiner "didn't really uncover the stones we all know are out there," he said. Starke said Washington Mutual's trust preferred securities, also known as the REIT series securities, fell by half after the examiner's report came out.
Dimon Beset by Bad WaMu Loans as JPMorgan Makes Overseas Push
by Dawn Kopecki - Bloomberg
Jamie Dimon wanted Washington Mutual Inc. and he wanted it bad. The JPMorgan Chase & Co. chief executive officer was determined to expand on the West Coast, and Seattle-based WaMu, as it was called, was a prime target. Dimon had a team of auditors poring over WaMu’s books in March 2008, at the same moment the Treasury Department was pressing him to acquire struggling investment bank Bear Stearns Cos.
While he initially couldn’t make a deal for the Seattle lender, JPMorgan did buy WaMu in September 2008 after it was seized by the Federal Deposit Insurance Corp., which meant the assets came at a bargain price of $1.9 billion, Bloomberg Markets magazine reports in its December issue. The 2,200 WaMu branches in California, Washington and 12 other states gave JPMorgan’s consumer bank, Chase, a total of 5,410 branches -- the second-biggest network in the nation. And it moved Chase to first from third in deposits, with $905 billion after the deal closed.
Dimon, 54, got what he wanted -- and a lot that he didn’t want. JPMorgan is now saddled with $74.8 billion in nonperforming home loans inherited from WaMu, a third of the $230.7 billion in mortgages on its books. The WaMu losses are just one of the afflictions besetting the man who, in the midst of the recession two years ago, was dubbed the world’s most powerful financial executive by the New York Times and labeled President Barack Obama’s “favorite banker.”
New York magazine called him “Good King Jamie,” while a biography of Dimon by author Duff McDonald is entitled Last Man Standing (Simon & Schuster, 2009). Back in 2008, Douglas Ciocca, managing director of St. Louis-based asset manager Renaissance Financial Corp., compared Dimon with J. Pierpont Morgan himself, who helped rescue the financial system in the crash of 1907. “He’s been a voice of reason throughout the industry pretty much throughout the financial crisis,” Ciocca said.
A lot has gone wrong for Dimon since those halcyon days. Both the WaMu mortgages and JPMorgan’s own home-equity loans are spilling red ink. Dimon’s commodities-trading team, led by Blythe Masters, has suffered a big setback. Dimon complains that hundreds of millions of dollars in profits will be lost to the Obama administration’s new financial regulations, which he fought unsuccessfully to derail.
Still more potential profits will be lost to the new Basel rules, which will increase capital requirements for banks worldwide beginning in 2013. The Basel Committee on Banking Supervision pushed back the date the capital rules would take effect because of the fragility of most of the big banks in the U.S. and Europe. In consumer banking -- JPMorgan’s biggest revenue source -- the bank is pushing against a regulation limiting it to 10 percent of national deposits. With more than $2 trillion in total assets, JPMorgan is now the second-biggest U.S. financial institution by assets, after Bank of America Corp.
It’s the biggest U.S. credit card company, with $137.4 billion in outstanding loans, followed by Bank of America and Citigroup Inc. The latest bad news is that the Securities and Exchange Commission is investigating whether JPMorgan failed to tell investors that an Evanston, Illinois-based hedge fund called Magnetar Capital helped select subprime mortgages for a collateralized debt obligation, or CDO, that the bank created, a person familiar with the matter said yesterday.
Magnetar later bet against the security, the person said. JPMorgan spokeswoman Kristin Lemkau said the company, “like other firms, has received inquiries from the SEC related to collateralized debt obligations. We are cooperating fully with these inquiries.” The bank’s shares dropped as much as 1.4 percent after the investigative Web site ProPublica disclosed the probe yesterday, closing down 21 cents, at $37.42. They fell 1 percent more to $37.04 by 11:55 a.m. in New York today.
Dimon has ambitious plans for overseas expansion, yet is hemmed in by banks with big international franchises, especially in the so-called BRICs: Brazil, Russia, India and China. Just a quarter of JPMorgan’s total revenue comes from outside the U.S., compared with more than half for Citigroup, says Anthony Polini, an analyst at investment bank Raymond James Financial Inc. International business, however, accounted for 61.6 percent of JPMorgan’s net income in 2009.
Dimon is likely to expand overseas through acquisitions, Polini says -- the New York banker’s approach since he linked up right out of Harvard Business School in 1982 with Sanford Weill and helped Weill build the financial conglomerate that became Citigroup. Yet Dimon has made only one major acquisition since WaMu. He’s been too busy putting out fires. In addition to the WaMu losses, Dimon has to deal with $113 billion in risky subprime, home-equity and adjustable-rate loans that JPMorgan originated.
In October, the bank halted foreclosures on thousands of homes when lawyers for homeowners said that JPMorgan, Bank of America, Ally Financial Inc. and other big banks had been “robo-signing” foreclosure documents without verifying their accuracy. JPMorgan temporarily stopped foreclosures in the 23 states where they are processed through the courts, later expanding the number to 41. Bank of America, the nation’s biggest mortgage holder, stopped selling off homes in all 50 states before reversing course.
Meanwhile, Dimon’s standing in Washington has declined since he lobbied against parts of Obama’s financial regulation law, which imposes new capital requirements on banks, forbids proprietary trading and imposes new regulations on the trading of derivatives, of which JPMorgan is the U.S.’s biggest dealer.
Dimon wasn’t included in the photo op when the bill was signed, and he was absent from a May White House state dinner attended by American Express Co. CEO Kenneth I. Chenault, Morgan Stanley’s James Gorman and Bank of America’s Brian T. Moynihan, among other Wall Street leaders. When a shareholder asked Dimon during JPMorgan’s annual meeting in May whether he was still Obama’s favorite banker, he replied, “I heard he has a new one.”
Dimon, a Queens, New York, native, is well-known for his refusal to mince words. When he dresses down subordinates, politicians or the media, he uses profanity liberally, according to people who have heard him. In June, students at Syracuse University protested when he was invited to give the school’s commencement address.
Lap Dogs and Sycophants
He went ahead with the speech and congratulated them for speaking their minds. “Throughout my life and throughout this crisis, I’ve seen many people embarrass themselves by failing to stand up, being mealy-mouthed and acting like lemmings by simply going along with the pack,” he told the graduates. “Along the way, you’re going to face a lot of pressure -- pressure to go along, to get along, to toe the line. Have the fortitude to do the right thing, not the easy thing. Don’t be somebody’s lap dog or sycophant.”
Dimon anticipated that his crown was likely to be knocked askew. In 2009, he told attendees at a meeting, “I know exactly what the headline will say when I make a mistake: ‘Dimon Loses Luster,’” according to two people who heard the comments. Yet Dimon’s bank is still the brightest star in a dim firmament. While JPMorgan’s stock lost 14.2 percent in the three years through 11:54 a.m. in New York today, investors did far worse buying the shares of its competitors. Citigroup shares were down 88.9 percent in the same three years, while Bank of America’s return was minus 74.8 percent and Wells Fargo & Co.’s stock fell 19.9 percent.
“Revenue headwinds such as slow loan growth, slim profit margins and higher regulatory costs should continue to hammer bank revenue not only next year but for the decade,” says Mike Mayo, an analyst at Credit Agricole Securities USA Inc. in New York. “We think 2011 will be indicative of a year in a decade for banks that has the worst revenue growth since the Depression.”
The debacle in the housing market is still the biggest headache for U.S. banks. Payments on some 8 million U.S. mortgages were delinquent in late September, and almost 7 million of those may end up in foreclosure, says Laurie Goodman, a senior managing director at Austin, Texas-based Amherst Securities Group LP.
11.5 Million Seizures
Those projections exclude the 200,000 additional borrowers that become delinquent each month for the first time, she says. In total, Goodman estimates that 11.5 million homes could be repossessed by banks during the next five years. Profits are also being squeezed by the Federal Reserve’s policy of keeping interest rates persistently low, which had helped boost bank earnings during the worst of the credit crisis, says Matthew O’Connor, an analyst at Deutsche Bank AG in New York. The Fed’s near-zero target rate for interbank overnight lending is compressing banks’ net interest margins, the difference between what they pay to borrow money and what they get for loans and securities.
“It’s a massive issue,” O’Connor says. “As you look out over the next few quarters, it’s a potentially very dire situation for the overall industry.” JPMorgan’s results for the third quarter confirmed O’Connor’s pessimism. Margins fell by 31 basis points to 3.01 percent at JPMorgan from March 31 to Sept. 30. (A basis point is 0.01 percentage point.) Combined with lower lending volumes, the reduced margins translated to a decrease in net interest income of $1.2 billion.
While third-quarter profit rose 23 percent from 2009 to $4.42 billion, the company generated 11 percent less revenue, at $23.8 billion. The profit included $1.5 billion the bank took out of its reserves against bad credit card loans. “Investors are still trying to figure out where revenue is going to come from when they stop being able to release reserves,” says Jason Tyler, a senior vice president at Ariel Investments LLC in Chicago. “That’s not clear yet.”
There may be more bad news hidden in JPMorgan’s books. The bank set aside $30 billion against bad WaMu loans when it acquired the thrift in 2008. Dimon predicted that number could rise by $24 billion if unemployment hit 8 percent. Unemployment was 9.6 percent in October, yet JPMorgan had only upped its reserves by an additional $3 billion. “WaMu was a top-to-bottom subprime lender,” says Paul Miller, a bank analyst at FBR Capital Markets Corp. in Arlington, Virginia. And its branch network outside California is not worth much, he says. “They were very expensive branches, not well placed.”
The company told analysts last month that the WaMu mortgage portfolio could cost $3 billion more if losses continued at current rates. “The portfolio is performing better than expected in this type of environment,” says Joe Evangelisti, a JPMorgan spokesman. Dimon says he doesn’t expect profits to be dented much by the foreclosure scandal. “It will cost us some money to go back and make sure it’s done right,” he told analysts on the Oct. 13 earnings conference call. “It will delay some foreclosures. But the whole mortgage issue costs us so much money now, to me it will be incremental.”
He said that no one had been evicted who shouldn’t have been. JPMorgan is the third-largest mortgage servicer in the U.S., with 13 percent of the market as of June 30, according to industry newsletter Inside Mortgage Finance.
On the same day Dimon made his statement, attorneys general in all 50 states announced a joint investigation into whether banks and loan servicers used false documents and signatures to foreclose on hundreds of thousands of homeowners. In September, lawyers for defaulting borrowers disclosed that a mortgage executive at Chase Home Finance in Florida said in a May 17 deposition that she was among eight managers who together signed about 18,000 affidavits a month attesting to facts in foreclosure cases without personally checking loan records.
JPMorgan said on Oct. 13 that it was reviewing the documents for 115,000 loans. Nancy Bush, an analyst at Annandale, New Jersey-based NAB Research LLC, says JPMorgan can’t rid itself of the foreclosure mess so easily. “Dimon was putting a happy face on this issue,” she says. “He’ll review 115,000 foreclosures now in process. But what about the rest that have already occurred?”
Brian Battle, vice president of trading at Performance Trust Capital Partners LLC in Chicago, says the bank’s foreclosure flaws are just becoming apparent. “That can be a big long-term problem, very expensive,” he says. “The whole can of worms is wide open.” Even as Dimon swims through a sea of trouble, he can brag that JPMorgan remains the strongest big bank in the nation. It’s the only major bank to have turned a profit in every quarter since the crisis erupted in late 2007. Per-share earnings have grown 14-fold since hitting a six-year low of 7 cents in the fourth quarter of 2008. They were $1.01 in the third quarter.
The bank has generated $29.9 billion in net income since taking over Bears Stearns in March 2008 -- an acquisition that has been a huge boon to JPMorgan’s investment banking franchise. When JPMorgan acquired Bear Stearns and WaMu, Dimon “had the strongest balance sheet in the industry,” says Robert Willumstad, a former Citigroup chief operating officer who has known Dimon since they both worked at Baltimore-based Commercial Credit Co. in the 1980s. “That’s the exact position you want to be in: You want to be the strongest player in the marketplace when the government turns to you and says: ‘We’ve got a problem. Can you take it off our hands?’”
Dimon’s surpassing skill is his ability to hold down costs, efficiently integrate new acquisitions and minimize risk, Willumstad says. During his four years as CEO of Chicago-based Bank One Corp., from 2000 to 2004, Dimon engineered a dramatic turnaround that took the bank from a $511 million loss in 2000 to a $3.5 billion profit in 2003. When Bank One merged with JPMorgan in 2004 in a $58 billion deal, CEO William Harrison named Dimon president and chief operating officer. Dimon overhauled management, shuttered lagging businesses and instituted monthly management reviews in local branches.
Dimon was named JPMorgan CEO on Dec. 31, 2005. He largely avoided investing in the subprime housing loans that crippled Bear Stearns and Merrill Lynch & Co. -- at least until he bought WaMu. Since 2006, JPMorgan has generated $59.7 billion in profit at a compounded annual growth rate of 22 percent.
Investment-banking fees, including those from trading and extending credit lines to clients, were $20 billion during the first nine months of 2010, up from $9.4 billion for the same period in 2004. Dimon honed his cost-cutting skills while managing the serial acquisitions that he and Weill used to build Citigroup. The two men worked together for 16 years, starting at American Express. The list of institutions Weill and Dimon then took control of reads like a history of modern finance: Travelers Group Inc., Shearson, Smith Barney, Salomon Brothers, Citicorp and Primerica, to name the largest.
By the time Dimon was fired from Citigroup in November 1998 by Weill and his co-CEO John Reed, Dimon and Weill had created a banking, trading and insurance behemoth of unprecedented size and scope.
In his various jobs under Weill, “Dimon didn’t suffer fools,” says former Nasdaq Stock Market Inc. CEO Frank Zarb, now chairman of consulting firm Promontory Financial Group LLC in Washington. Zarb, 75, met Dimon in 1987 at Commercial Credit, and they have remained close ever since. “He was young but struck me as really smart and he called them like he saw them,” Zarb says. Some called the young banker brash, Zarb adds. “I call it intellectually honest,” he says.
At JPMorgan, Dimon hasn’t deviated from the management practices that have brought him this far. JPMorgan’s acquisition of Bear Stearns, the fifth-largest U.S. securities firm at the time, has gone far smoother than that of WaMu.
The bank ended up paying roughly $1.5 billion in stock to close the deal. The Federal Reserve Bank of New York agreed to take $30 billion of the struggling investment bank’s mortgage- backed securities, collateralized debt obligations and other illiquid assets. JPMorgan assumed the first $1 billion in losses.
JPMorgan got billions of dollars in new investment-banking revenue and a prime-brokerage business serving hedge-fund clients out of the deal. The acquisition boosted 2008 second- quarter profits by $500 million.
JPMorgan’s investment bank carried the bank’s earnings through 2008 and 2009. Fees and trading revenue began to falter in 2010 due to the persistently weak economy and high unemployment. Dimon’s commodities division, run by Masters, was rocked in the second quarter by an undisclosed loss in its coal investments, when trader Chan Bhima took a position in the fuel just before prices plunged. Masters sought to reassure her team in an internal conference call on July 22, after what she called “extremely difficult” dismissals, defections and a 2010 first half in which some results were as much as 20 percent below expectations.
“Don’t panic,” Masters said in the 35-minute call, a recording of which was obtained by Bloomberg News. “No one’s going to get screwed. We’re not going to do crazy things on compensation at the end of the year.”
The company let go about 10 percent of the commodities front-office staff in the third quarter. JPMorgan also shuttered its commodities proprietary trading desk, affecting roughly 20 traders, most of them in London. They had to reapply for jobs elsewhere in the company. The company said it cut the desk to comply with the Dodd- Frank law, which limits banks’ ability to trade for their own account. Other proprietary traders are being moved to JPMorgan’s asset management division, where they will trade for clients.
Dimon doesn’t want to hear excuses for his executives’ failures. He has a sign in his office in big bold type that reads “No Whiners.” “It’s a looking-forward mentality: Don’t whine about it; just get it done,” says Ron Seiffert, whom Dimon hired from Huntington Bancshares Inc. to run Bank One’s small-business lending in 2002. Seiffert is now vice president of Ohio Dominican University.
Seiffert says Dimon displayed his philosophy when United Airlines filed for Chapter 11 bankruptcy protection in 2002, after being weakened by the 9/11 terrorist attacks. Bank One was one of the airline’s biggest creditors. Instead of scaling back his exposure, Dimon decided to extend even more credit to the airline. It was a risky bet that eventually paid off, Seiffert says. “He said: ‘We made this decision. If we made the wrong decision, I’ll go home, I’ll have a couple of martinis, I’ll wake up the next day and we’ll come back,’” Seiffert says.
Dimon doesn’t always play the role of F-word-slinging tough guy. Executives, including junior managers, whose work catches his attention might get invited to sip wine in his office after markets close on Friday afternoon, current and former employees say. It’s a tradition begun under Weill, when Dimon was his chief of staff at American Express.
Dimon has been both the victim and author of executive suite shakeups. After Harrison left the bank in 2006, Dimon replaced many of his top staff with former colleagues from Bank One and Citigroup. The most recent executive shuffle took place in September 2009, when Bill Winters, now 48, a co-CEO of JPMorgan’s investment bank, was fired and Dimon named James “Jes” Staley CEO of the unit. Steven Black, the other investment bank co-CEO, was moved up to vice chairman; he has no operational departments reporting to him, people familiar with the matter say. Black and Winters declined to comment for this story.
Staley, 53, joined JPMorgan in 1979. He started out in investment banking on the Brazil desk, later running JPMorgan’s equity and capital markets group as well as its asset management division. Dimon’s brain trust -- the people he gathers around him in times of crisis -- are a mix of new and old bankers, people familiar with his decision making say. Dimon said in March that he planned to rotate senior executives with an eye toward picking a successor. He’s been grooming a handful of long-time loyalists for the spot for years.
Among them, besides Staley, are Heidi Miller, who was promoted in June to head of international operations after having started as Dimon’s assistant at Travelers Group in 1992; Charlie Scharf, head of retail services, who first worked with Dimon at Commercial Credit; Mike Cavanagh, head of treasury and security services, who was hired by Dimon at Salomon Smith Barney in 1993 and then again at Bank One in 2000; and Jay Mandelbaum, whom Dimon hired away from consulting firm McKinsey & Co. in the mid-1990s and who now runs JPMorgan’s strategy and business development division.
Dimon has also grown close to Stephen Cutler, the enforcement chief of the Securities and Exchange Commission under President George W. Bush who joined JPMorgan as general counsel in 2007. One of the inner circle’s challenges is to deal with the raft of financial regulations passed by the Obama administration in July. Dimon told investors on Sept. 14 that the bank will lose about $750 million in profits just as a result of new restrictions on the fees and interest it can charge on credit cards.
“No bank has more to lose with the new financial service rules than JPMorgan,” says Joshua Rosner, a bank analyst at independent research firm Graham Fisher & Co. in New York. JPMorgan is especially vulnerable because it’s the U.S.’s biggest creator and trader of derivatives, securities whose value is derived from the price of stocks, bonds or commodities, Rosner says. The notional value of the bank’s outstanding derivatives contracts -- that is, the value of the securities underlying them -- was $75.6 trillion as of June 30, according to the Office of the Comptroller of the Currency.
A JPMorgan team led by Masters was among the first sellers of the most controversial form of derivative, the credit-default swap, which provides insurance against a security’s default.
The Dodd-Frank Act requires banks to move derivatives trading to separately capitalized subsidiaries, which Dimon is in the process of doing at what he says is a cost of $1 billion in lost revenue. Standard derivatives must be traded on exchanges, rather than over the counter. “It’s an operational nightmare,” Dimon said on a July conference call with analysts, of the bill’s restrictions on derivatives trading. “In my opinion, it’s highly ill-conceived, doesn’t reduce risk at all.”
Dimon says he is looking for ways to pass on all of the extra regulatory costs to consumers and corporate clients. Fewer borrowers will get loans and credit cards, he says. He estimates that the passing on of costs will reduce the bank’s retail customer base by about 5 percent. “We are going to earn it all back, whatever the number is,” Dimon told investors at a Sept. 14 conference hosted by Barclays Capital in New York.
The bank hopes to replace some of its lost profits by expanding overseas, particularly in the booming BRIC countries. “These emerging markets, primarily in Latin America and Asia, offer much better economic prospects than the U.S. or Western Europe,” Raymond James’s Polini says. “JPMorgan is ramping up to go head-to-head with Citigroup.” Miller says JPMorgan needs to expand internationally because that’s where its corporate customers are.
“Multinationals operate in sometimes more countries than we do,” Miller said at the time she took her new job. “We increasingly see our clients look to us to provide services and solutions throughout the world. We want to make sure we can do it for them seamlessly.” Investment bank head Staley laid out ambitious plans in February to double the bank’s market share in Asia in the next few years. U.S. banks, however, could have a difficult time widening their footprint there, Peter Sands, CEO of London-based Standard Chartered Plc, told Bloomberg News in October.
Standard Chartered gets 90 percent of its revenue from Asia, Africa and the Middle East, and he says both international banks like his and local competitors could block new foreign intrusions. “The best of the competition probably comes from the best of the local banks in most of our markets rather than from the international class,” he says.
One sector where JPMorgan already has global stature is commodities. Under Masters, JPMorgan has acquired a half dozen international concerns, including UBS AG’s global agriculture and Canadian commodities divisions in 2009. Buying Bear Stearns gave the bank a business trading natural gas, coal and weather contracts.
Last year, the company completed a $1.7 billion deal to buy parts of commodities trader RBS Sempra, a joint venture between Royal Bank of Scotland Group Plc and Sempra Energy. And in March 2008, the bank made itself a big player in European carbon trading when it bought Oxford, England-based ClimateCare, which sponsors projects that help reduce carbon emissions.
“What we have pulled off over the last three years is unbelievable,” Masters said during the July internal call. “We now, post-merger and post-all the other work we’ve done over the last few years, have a phenomenal physical capability that’s global, that involves storage, transportation across the world.”
Dimon, like his counterparts at other banks, is waiting impatiently for the housing crisis to ease so the bank can rid itself of its huge portfolio of bad loans. In addition to the WaMu writedowns, the bank faces an avalanche of litigation over allegedly predatory and fraudulent WaMu mortgages and has set aside a total of $3.5 billion in reserves to cover the cost of mounting lawsuits. Dimon blames the continuing home-loan losses on house prices that keep falling, unemployment that remains high and an economy that’s recovering at a snail’s pace. He predicted in April 2008 that home prices would fall by a maximum of 9 percent over the rest of that year; they fell by 16.5 percent.
Meanwhile, the company set aside $34.5 billion in reserves against potential losses on its mortgage, credit card and auto loans in 2009, up from $20.4 billion the year before. “It is just going to take a little bit of time before the mortgage losses are run off and things normalize,” Dimon told investors in September. That means Dimon has more time to mull the question of whether buying Washington Mutual was that rarest of events in his professional life: a bad deal.