"An afternoon on the beach"
Stoneleigh: The counter-trend rally from March 2009 has lasted a long time, significantly longer than we initially thought it would. This is not particularly surprising, since rallies can take many complex forms and market timing is probabilistic. We were predicting a rally when most were calling for an accelerated decline. We did that because we see the world in terms of human herding behaviour, which is a vital driver of where we are collectively going. In March 2009, people were almost universally bearish, so we were looking for an upturn.
A new trend takes time to disseminate and become received wisdom, starting slowly, reaching critical mass, and then shifting sharply in the new direction. By the time the new received wisdom has become so entrenched that there is almost universal agreement, there is virtually no one left to act on that opinion and carry that trend any further in the same direction. That was the case in March 2009, and it is the same now, albeit in the opposite direction. Now strongly positive sentiment indicators suggest that the rally is ending, and its end should also bring to an end the long period of extend-and-pretend in which our societies have been sleep-walking for 18 months.
We have been living through a long period of suspended animation, with resurgent confidence and renewed suspension of disbelief taking the pressure off both central authorities and illiquid asset markets. The interventions of central bankers and treasuries appear to work where the prevailing psychology is supportive - where the collective is not in the mood to call their bluffs.
This leads to praise for those same authorities for saving the system, on the assumption that they are in fact in control. In the case of asset markets, values have remained unclear because so few assets have been changing hands. Since there has been no sceptical probing for price discovery, it is still possible to maintain the fantasy that these so-called assets are worth what they once were. They can still be marked on the books of banks at 100 cents on the dollar, giving the banking system the illusion of health.
This is partly because the big players see it as being in their best interests to stick together in order to prevent the cold light of day shining too strongly on the festering contents of their vaults. Such periods always come to an end eventually, typically when interests between the big players diverge. The Fed and the Treasury have been hoping that they can maintain the illusion long enough for confidence to return on its own, but this is not realistic with the unprecedented overhang of leverage in our global financial system.
When the rally ends, that divergence of interests is likely to intensify, and it may not take long to reach breaking point. With the end of the rally, the psychology supportive of cooperative or top-down actions will end. This environment will be very unkind to both central authorities and illiquid asset markets. Plans will fall flat on their faces, bluffs will be called and price discovery (at drastically lower levels) will reprice whole asset classes at a stroke. At this point the insolvency of the banking system will be laid bare.
The repricing of 'assets' such as derivative contracts on the books of banks is comparable to the repricing of a neighbourhood in a property price collapse. Initially, in either case there is a wide gap between what sellers are prepared to accept and what buyers are prepared to pay. So long as no one bridges that gap, there is no price discovery. Eventually, however, a CDS derivative contract holder with an interest in seeing something fail for profit will force it to happen, or a property seller will get get desperate enough to drastically cut his price.
In each case, price discovery results. In the case of property, inventory builds up while the price gap persists. Sellers eventually try to bridge the gap to the downside, but even as they do so, what buyers are prepared to offer is also falling. Those who cut their prices too little, too late, are likely to follow the market all the way down. Whole neighbourhoods can be repriced again and again by the actions of a few sellers at the margins. Most people need do nothing for the price of their asset to fall, placing them potentially underwater on their mortgages. Underwater mortgages in turn become an albatross round the neck of the property market. Liquidity will be limited in real estate for a very long time.
As we discussed in the last post, the leverage of a credit expansion creates excess claims to underlying real wealth, and that means we are all playing a giant game of musical chairs, with perhaps one chair for every hundred people. Extend and pretend is the period of time when the music is still playing and everyone is frantically dancing, even those who understand the game, as many of them are arrogant enough to think they will be able to get out at a top. This will prove not to be true for many, hence even many very wealthy people are going to be ruined, as they were in the Great Depression. To use another analogy, cashing out at a top bears some resemblance to a fire in a theatre, where everyone is trying to get out at once through a small exit.
This is not going to play out slowly, although the build up can be tortuously slow. People should be thinking of the extra time they have had as a result of an extended rally as a precious gift, not as a reason for complaint. Deleveraging will come soon enough, and when it does it will be devastating. We should appreciate every day we get before it begins in earnest, as an opportunity to put our houses in order rather than to wring another ounce of profit out of a dying system by continuing to play the game. We need to walk calmly away from the game before the music stops in order to minimize the consequences of being wrong. Early is fine, but late is not.
Allied Irish Bank suffers massive withdrawals
by Phillip Inman and Jill Treanor - Guardian
Ireland's financial woes deepened today after its second largest bank revealed that an enormous outflow of funds during the year had tripled its reliance on central bank funding. During a day of feverish speculation over the size of the bailout being negotiated by the Irish government with the EU and International Monetary Fund, Allied Irish Bank reported that its dependence on "monetary authorities" had risen to €27bn (£23bn) from below €10bn in June.
The bank admitted it was increasingly reliant on central bank funding after suffering €13bn of outflows this year, matching the large loss of funds reported earlier by the country's largest bank, Bank of Ireland. In a gloomy statement, the bank, which is now more than 90% state-owned, said: "The outlook in our markets is uncertain with additional stress likely from the implementation of the Irish and UK budgets. We are carefully and thoroughly assessing these impacts and market conditions."
Irish ministers and officials from the EU and IMF began talks today over a possible €100bn bailout that would secure government debts, which have rocketed since it agreed to underwrite the country's five main banks. Ministers, including the prime minister Brian Cowen, have consistently maintained the country remains solvent and self financing. But last week interest rates on Irish government debt jumped to record levels on fears that the banking sector's debts would overwhelm the state's finances next year.
Investors fear a government programme of spending cuts and tax rises will accelerate the number of households and businesses reporting bad debts in 2011, which in turn will hit the banks. Amid speculation that EU and IMF officials were prepared for protracted negotiations after allegedly booking a suite of rooms at a five-star Dublin hotel for the next three weeks, concern grew that the price of Ireland's bailout would be a loss of control over its tax rates and budget.
Finance minister Brian Lenihan denied rumours that he was preparing to raise Ireland's much cherished corporation tax rate of 12.5% to nearer the EU average as the price of loans and guarantees from the EU and IMF. His position was undermined by central bank governor Patrick Honohan, who broke ranks in an interview with broadcaster RTE to say he expected a deal to go ahead. "The expectation is that negotiations will be effective and a loan will be made available and drawn down as necessary," he said.
"The ECB would not send large teams if they didn't believe first of all that this was something they could agree to … that there is a programme that is fully acceptable to them that could be designed and that is likely to be accept to Irish government and Irish people."
Cowen defended his government's decision to underwrite the banks, insisting it was the only sensible route to prevent a collapse in confidence and a devastating bank run. But Eamon Gilmore, the leader of the opposition Labour party, said Ireland had suffered the darkest week in its history since the Civil War nearly 90 years ago.
The pressure group Debt and Development Coalition Ireland (DDCI), which was formed in the aftermath of the financial crisis, argued that the IMF had frustrated efforts to deliver justice and failed the poorest people in countries around the world. Nessa Ní Chasaide, DDCI co-ordinator, said: "The notion that the IMF is needed to promote 'tough love' in crisis situations, whether in impoverished countries or in Ireland, is deeply misleading, as governments must first and foremost account to their citizens when making decisions that will affect their everyday lives.
"Since joining the IMF in 1957, Ireland has stood by as the IMF impoverished countries around the world. As Ireland and other eurozone countries now face a similar prospect, it is high time to end the undue and damaging influence of such an undemocratic financial institution."
Irish lenders have become more reliant on European Central Bank funding after being frozen out of wholesale markets. The amount of ECB loans to the country's banks rose 7.3% from the previous month to €130bn in October, according to Ireland's central bank. AIB's deposits fell from €74bn to €61bn during the year. The bank also admitted it would need a cash injection of €6.6bn from the government to prop up its capital reserves, up from €5.4bn, after it abandoned the sale of its UK businesses.
Eric Cantona, former Manchester United soccer great, calls for bank protest
by Kim Willsher - The Observer,
As students and public sector workers across Europe prepare for a winter of protests, they have been offered advice from the archetypal football rebel Eric Cantona. Cantona was once a famous exponent of direct action against adversaries on and off the pitch. In 1995 he was given a nine-month ban after launching a karate kick at a Crystal Palace fan who shouted racist abuse at the former Manchester United star after he was sent off.
But while sympathising with the predicament of the protesters in France, the now retired Cantona is urging a more sophisticated approach to dissent. The 44-year-old former footballer recommended a run on the cash reserves of the world's banks during a newspaper interview that was also filmed. The interview has become a YouTube hit and has spawned a new political movement.
The regional newspaper Presse Océan in Nantes had asked Cantona about his work with the Abbé Pierre Foundation, which campaigns for housing for the destitute and for which he produced a book of photographs last year. But the discussion soon moved on to other issues, including the demonstrations in France and elsewhere against government cutbacks in the new era of austerity.
Cantona, wearing a bright red jumper, dismissed protesters who take to the streets with placards and banners as passé. Instead, he said, they should create a social and economic revolution by taking their money out of their bank. He said: "I don't think we can be entirely happy seeing such misery around us. Unless you live in a pod. But then there is a chance... there is something to do. Nowadays what does it mean to be on the streets? To demonstrate? You swindle yourself. Anyway, that's not the way any more.
"We don't pick up weapons to kill people to start the revolution. The revolution is really easy to do these days. What's the system? The system is built on the power of the banks. So it must be destroyed through the banks. "This means that the three million people with their placards on the streets, they go to the bank and they withdraw their money and the banks collapse. Three million, 10 million people, and the banks collapse and there is no real threat. A real revolution.
"We must go to the bank. In this case there would be a real revolution. It's not complicated; instead of going on the streets and driving kilometres by car you simply go to the bank in your country and withdraw your money, and if there are a lot of people withdrawing their money the system collapses. No weapons, no blood, or anything like that." He concludes: "It's not complicated and in this case they will listen to us in a different way. Trade unions? Sometimes we should propose ideas to them."
Cantona's call appeared to touch a popular chord and generated an instant response. Nearly 40,000 people have clicked on the YouTube clip, and a French-based movement – StopBanque – has taken up the campaign for a massive coordinated withdrawal of money from banks on 7 December. It is claimed that more than 14,000 people are already committed to removing deposits. The movement is also gaining increasing attention in Britain.
The trio of French Facebook users now leading the campaign have appealed to people across Europe to provoke a bank crash. "It is we who control the banks, not vice versa," they write.
In a fuller statement on the website Bankrun2010.com, the organisers write: "Our call has been more successful than we dared think. Our action is a people's movement... we're not seeking to destroy anyone in particular, it's the corrupt, criminal and moribund system that we have decided to oppose using what means we can, with determination and within the law." The statement is signed by Géraldine Feuillien, 41, a Belgian filmmaker, and Yann Sarfati, 24, an actor and director from France.
Sarfati said he and his friends had simply wanted to pass on Cantona's video clip, but had found themselves caught up in a global "citizens' movement". "We were surprised by the interest and the buzz it created on the internet. It has really spread; there are now Facebook events in Italy, Romania, Bulgaria and even Korea," Sarfati said.
"We're not anarchists, nor linked to any political party or trade union; we're not even an organisation. We just thought this was another way of protesting." He added: "In between doing publicity campaigns for L'Oréal, Cantona has this revolutionary side. He earns a good living, but obviously he has a social conscience and I think he is sincere."
Valérie Ohannesian, of the French Banking Federation, said she thought that the appeal was "stupid in every sense" and a charter for thieves and money-launderers. "My first reaction is to laugh. It is totally idiotic," she told the Observer. "One of the main roles of a bank is to keep money safe. This appeal will give great pleasure to thieves, I would have thought." She also doubted the practicalities of the suggestion. "If Mr Cantona wants to take his money out of the bank, I imagine that he'll need quite a few suitcases," she said.
Ireland faces political turmoil
by Ainsley Thomson and Jason Douglas - Wall Street Journal
Ireland's ruling Fianna Fail party's grip on power became even more tenuous Monday after its junior coalition partner said it would pull out of the government in the new year. Green Party leader John Gormley called for a general election to be held in the second half of January, adding that he had informed Prime Minister Brian Cowen of the decision. "The past week has been a traumatic one for the Irish electorate. People feel misled and betrayed," Mr. Gormley said. "We have now reached a point where the Irish people need political certainty to take them beyond the coming two months."
The Green Party said it would support the passage of the government's four-year plan—which will detail how the government will make €15 billion ($20.53 billion) in spending cuts and tax rises—as well as the 2011 budget on Dec. 7 and the negotiations on the details of the aid package. But Eamon Ryan, the Green Party's minister for communications, energy and natural resources, told Irish state broadcaster RTE that his party will resign from government if Fianna Fail doesn't agree to its request for a January election.
The announcement comes after the Irish government Sunday said it had formally applied for tens of billions of euros in aid from the European Union and the International Monetary Fund. The Green Party's decision to pull out of the government in the new year dashed hopes that the deal with the EU and IMF would ease investor concerns about the euro zone's fiscal trouble spots.
The Green Party's withdrawal of support beyond January means a new coalition government will have to follow through on its predecessor's promises, or seek to renegotiate. The Irish government is currently a coalition of Fianna Fail, the Green Party and independent lawmakers. The Green Party has six of the 166 seats in Ireland's lower house of parliament, compared with Fianna Fail's 71 seats.
Eamon Gilmore, leader of the opposition Labour Party, said an election should be called as soon a possible, saying it wasn't desirable that the negotiations with the EU and IMF were being conducted by a government "on its last legs." Enda Kenny, leader of Fine Gael, the largest opposition party, also called for an immediate election, saying the Green Party's announcement had created even more uncertainty.
The pressure on Fianna Fail increased further when two independent lawmakers—Jackie Healy-Rae and Michael Lowry, both of whom previously supported the government—said they were undecided on whether they would back Fianna Fail on the budget. Fianna Fail also faces a by-election in the constituency of Donegal South West in Ireland's northwest Thursday. The region has long been a stronghold of the party, but Sinn Fein, a traditionally smaller left-of-center party, is in contention and may win the seat. That would reduce the government's majority to two seats from three, with three further by-elections due in coming months.
It is unlikely that Fianna Fail would be in a position to take part in a new coalition government. According to an opinion poll conducted by Red C for the Sunday Business Post newspaper, only 17% of voters would back it in a new poll, a record low.
Ireland fears civil unrest as bank crisis deepens
by Henry McDonald and Andrew Clark - Guardian
Trade union leader warns of riots if government imposes further 'draconian' cuts to public sector
One of Ireland's biggest trade unions warned today that the nation was on the brink of civil unrest as government officials negotiated a multibillion euro bailout for the country's ailing banks. The Technical Engineering and Electrical Union said further "draconian" public sector cuts of €15bn (£13bn) over four years could lead to street disorder. It urged a campaign of civil disobedience unless the taoiseach, Brian Cowen, calls an immediate election. An emergency cabinet tomorrow will discuss the new round of cuts.
"When the measures being proposed are heaped on top of the €14.5bn cuts already implemented in the last three brutal budgets, life in Ireland will be unbearable," said the TEEU leader, Eamon Devoy. A group of 16 officials from the International Monetary Fund and European Central Bank are staying in Dublin's luxury Merrion hotel, holding talks throughout the weekend with the Irish government and Ireland's central bank. Financial sources told the Observer that a strategy could be announced as soon as Monday to stabilise Ireland's banks.
A first priority is to restore confidence and halt an outflow of cash – Anglo Irish Banks revealed on Friday that customers have withdrawn €13bn of deposits this year. Measures under consideration include hiving off rotten loans into a freestanding "bad bank".
An injection of capital into the banks could be followed by a broader sovereign bailout in the form of a multibillion euro "contingency loan" from the IMF and the ECB. Government sources said the loan would be available for Ireland to draw on if it ran out of money from the beginning of 2011. Asked about any preconditions that might be imposed, one senior source within the ruling Fianna Fail party said: "Because it's a loan that we will have to pay back, they won't be seeking anything major in return like higher corporation tax for Ireland."
Ireland's unusually low 12.5% rate of corporation tax, which has lured investment to the country by multinationals such as Google and Microsoft, is a bone of contention among European leaders. France's president, Nicolas Sarkozy, today said he expected Ireland to increase the tax. "There are two levers to use: spending and revenues," he said at a Nato summit in Lisbon. "I cannot imagine that our Irish friends [would not use] this because they have a greater margin for manoeuvre than others, their taxes being lower than others."
Ireland's European allies fear that without swift action Ireland's debt crisis could become contagious, weakening confidence in Greece, Portugal, Spain and in the euro as a currency. William Hague, Britain's foreign secretary, expressed uncertainty about the future of the single currency – asked on the Today programme whether he felt the euro could collapse, he said: "I very much hope not. Who knows?"
David Begg, general secretary of the Irish Congress of Trade Unions, said the union movement was calling for mass protests on 27 November to "allow ordinary working people to voice their opposition to a policy that could destroy 90,000 more jobs".
Portugal next as EMU's Máquina Infernal keeps ticking
by Ambrose Evans-Pritchard - Telegraph
The Portuguese seemed baffled - and pained - that investors should link their country in any way with Greece or Ireland. I am afraid they must come to terms very soon with some unpleasant facts.
So must Europe’s leaders, who comfort themselves that Greece is a special case because it cheated, and that Ireland is a special case because it allowed its "Anglo-Saxon" banks to go berserk. They have yet to acknowledge the deeper truth that monetary union has insidiously destabilised much of Europe and trapped a ring of largely innocent countries in depression.
In my experience it is hazardous for English-speaking journalists to write about Portugal without being accused of betraying the Aliança Velha, or pursuing a perfidious Palmerstonian agenda. It is an article of faith - an Iberian trait - that Portugal is the victim of an orchestrated calumny intended to divert attention from a bankrupt Britain, or America. The rating agencies are deemed agents of Anglo-Saxon hegemony.
So with some trepidation, let me point out that Portugal will have a current account deficit of 10.3pc of GDP this year, 8.8pc in 2011, and 8.0pc in 2012, according to the OECD. That is to say, Portugal will be unable to pay its way in the world by a huge margin even after draconian austerity.
This is the worst profile in Europe. It requires a drip-feed of external funding that can be shut off at any moment, and undoubtedly will be unless the global economy goes full throttle into another boom. Or as the IMF puts it, "the longer the imbalance persists, the greater the risk the adjustment will be sudden and disruptive".
Note that Ireland - however wounded - will have a surplus of 0.7pc next year, and 3.2pc in 2012 as IT industries and pharma exports drive a rebound. The Irish "internal devaluation" may conceivably pay off. (Britain may also be in surplus, thanks to a sovereign currency that has taken some of the strain.)
Yes, Portugal’s public debt is manageable at 86pc of GDP - although even that figure is in question. Opposition leader Peder Passos Coelho said over the weekend that the real figure is 122pc, accusing the government of "fictitious" accounting. Be that as it, public debt is not the core problem. Private debt is one of the highest in the world at 239pc (Deutsche Bank data), and the events of the last two years have taught us that private excess lands on the taxpayer one way or another in a crisis. A chunk of this is owed to foreigners, and must be rolled over.
Portuguese banks have been well-behaved. There is no property bubble. But as the IMF points out in its Article IV report, the banks have a "heavy reliance" on external funding, equal to 40pc of total assets. It was a funding crisis that killed Northern Rock, not bad loans. The IMF also says Portugal has the eurozone’s most rigid labour markets, and that social transfer costs have risen to 22pc of GDP from 18.5pc in 2005. Productivity is stuck at 64pc of the eurozone average, unchanged since the early 1990s. The promised EMU catch-up effect never occurred.
Finance minister Fernando Teixeira dos Santos admits a "high risk" that Portugal will need a rescue, berating Germany for setting off the latest crisis by scaring investors with talk of bondholder haircuts. "We were like the soccer player ready to kick for goal, and then someone fouls us, but this time there was no penalty," he said. Well, up to a point Senhor.
He also let slip that if Portugal were not in the eurozone "the risk of contagion might be lower". Senhor, if Portugal were not in the eurozone, it would not be in this disaster at all. The country was still in surplus on its external accounts in the early 1990s. It was pushed by the risk-free illusions of EMU into the red to the tune of 109pc of GDP. Under the escudo - literally "shield" - it would never have been able to amass so much foreign debt, and would now be able to claw its way back to health with a weaker exchange rate.
The origins of this crisis go back to Portugal’s fateful decision to push for euro membership at least 20 years before it was ready. Lisbon then failed to tighten fiscal and credit policy enough to offset a fall in interest rates from 16pc to 3pc as Portugal prepared to join in the 1990s – if it is possible to offset monetary error on such a scale.
Portugal saw its competitiveness destroyed by the boom, and has never been able to get it back. The country has been in perma-slump ever since with a Teutonic currency that raises the bar ever higher. It has lost swathes of low-tech industry to Chinese and East European rivals faster than it can create high-tech alternatives.
Portugal has in a sense been the victim of EMU, a casualty of ideology, wishful thinking, and untested academic theories by Nobel laureates about optimal currency unions.
By the time the eurozone crisis began to blow up in Greece a year ago, it was probably too late already for Portugal. The government then made matters worse by letting its budget deficit creep higher over the first half of the year, while the rest of the Club Med slashed frantically. It is hard to see how Portugal will meet a deficit target of 7.3pc for 2010 agreed with EU.
Premier Jose Socrates hoped global recovery would lift Portugal off the reefs. Perhaps he had little room for manouvre anyway without a majority in parliament. Events caught up with him in September. He has at last been forced to impose the standard EMU mix of wage cuts and 1930s debt-deflation, causing the Left flank of his party to disintegrate as disgusted members peel off to the Communists and the eccentric Bloco.
Fiscal policy will be tightened by 4pc of GDP next year - as the economy contracts 1.4pc (IMF ) - in pro-cyclical torture likely to end badly in an economy with total debt of 325pc of GDP. The bond markets suspect that such a policy is self-defeating, and since they now know that Chancellor Angela Merkel is going to make them share the clean-up bill, they are ever less willing to fund the experiment.
The eurozone will face its moment of existential danger the day that Portugal is forced to tap the EU bail-out fund. A third rescue in months will push the combined bill towards €300bn (£257bn) and risk exhausting the political capital of EMU, leaving little left for Spain even if the European Financial Stability Facility can in theory handle one more domino.
Chancellor Merkel was assured in May that words would be enough to chase away speculators and restore calm to Europe’s bond markets, that the "shock and awe" effect of a €750bn safety-net would conjure away the crisis without the need for real money. This bluff is now being called.
What happens if Spain tips back into recession in 2011, and or when Spanish banks start coming clean on the true scale of their property losses, and Spanish companies have trouble rolling over foreign loans? What happens if Spanish 10-year bond yields creep above 5pc? Can Mrs Merkel go back to the Bundestag and request fresh money to boost the collateral of the EFSF in order to cope with the next casualty?
A reader asked me this week whether there is any graceful way to avoid this coming chain of disasters. Yes, there are two options, neither entirely graceful. The European Central Bank can print money like a drunken sailor, flood the bond markets with €2 trillion, and tank the euro against China’s yuan for good measure.
If the Germans refuse to accept this, they should abandon EMU at once, leaving France and southern Europe with the residual euro and the institutions of monetary union. Existing euro debt contracts would be upheld. Germany would revalue – alone or with Finns, Dutch, etc - so holders of Bunds would enjoy a windfall gain. France could revive the Latin Union of the late 19th Century, a more benign venture than the Máquina Infernal now asphyxiating Portugal, and deflating Spain.
Any better ideas out there?
Eyes return to Greece after Irish bail-out
by John Dizard - Financial Times
With the Irish "bail-out" moving to its sad denouement, the next sequence of events in the euro’s existential crisis is becoming clearer. Had the Irish banking sector’s ability to maintain funding not been resolved, the Spanish banking system would almost certainly have rapidly been seized up with the same problems. The Irish banks’ loss of wholesale deposits had precipitated the current crisis, and the same class of depositors had already begun to trickle out of Spain. The European Central Bank’s balance sheet was barely able to temporarily provide liquidity to the Irish; the effect of a Spanish deposit flight on the central bank does not bear contemplation.
So, the crisis caused by tardy, or even delusional, bank insolvency management has been dealt with, for the moment. This coming week, euro-area finance will turn back to sovereign insolvency, which means, for the moment, Greece.
This Monday, auditors from the International Monetary Fund, European Union, and ECB will have formally completed their review of Greece’s compliance with the terms of the May stabilisation programme. It is already understood that the spending and revenue targets for the Greek state will not have been met, though, of course, even more ambitious plans have been set for next year. Nevertheless, the next tranche of €9bn ($12bn) of EU-IMF money will be released next month, since apparent sincerity and new, revised promises are taken to count for as much as actual compliance.
From the point of view of the private sector market people, the outcome of this particular review is a crucial one. It means there will be no systemic crisis in December, which means the chances of getting through the month without losing the year’s profits, and bonuses, are very good. Reality can wait.
How long? Among the bankers and lawyers preparing for Greece’s forthcoming orderly default, there is disagreement over timing. Some believe the dramatic, shocking announcement and frantic public response should take place in the second quarter of 2011; others think some time in the third quarter would be more appropriate. A third quarter event is more in keeping with tradition, but judges in Germany and politicians in Greece are apparently getting tired of all this euro-folderol, and may move up the date, leaving more of the third quarter free for already-planned holidays.
With my own holiday planned for August, I take the moral position that it is better for everyone to face facts, book investment losses, and have further austerity imposed, sooner rather than later. The Greeks and their advisers are already much further along in their thinking than euro-officialdom. They realise that reaching a "successful" conclusion of the three-year adjustment process agreed with the euro leaders would be a disaster for their balance sheet.
As Greek bonds mature over that period, they are paid off in large part with new borrowings from Europe and the IMF, as well as with Greek banks’ discounting bond purchases with the ECB. That means Greece is exchanging outstanding debt that is legally and logistically easy to restructure on favourable terms with debt that is difficult or impossible to restructure. It’s as if they were borrowing from a Mafia loan shark to repay an advance from their grandmother.
As has been noted publicly by sovereign debt lawyers such as Lee Buchheit of Cleary Gottlieb, the former counsel to Argentina, 90 per cent of outstanding Greek bonds are governed by Greek law. That means the terms of a restructuring could be set by the rapid passage of a law through the Greek parliament allowing for the application of "aggregate collective action". So if a specific fraction, say 80 per cent or 90 per cent, of all Greek bondholders agree to a restructuring that lowers the net present value of Greek debt by, say, half, then the remaining "holdout" bondholders would be forced into accepting the same terms. Greek 30-year paper is now at 50 cents on the euro, – a good indicator for what the shorter term paper is worth.
In contrast, Greece’s advances from euro area countries, the IMF and the ECB are effectively un-restructurable. Unlike Argentina, say, which had a trade surplus at the time of its 2000-01 default, Greece needs continued financing, post default, for a trade deficit. That would not be available if it tries to stiff the IMF or ECB, let alone Germany and France. Think Zimbabwe. Also, as Whitney Debevoise, a sovereign debt lawyer with Arnold & Porter of Washington points out: "There is an incentive for a country to be an early mover on getting access to [European stability funds]." After all, it seems as though the German, and other "northern" taxpayers, will not accept an expansion of the European bail-out pot.
As Mr Debevoise further notes: "While the EFSF supposedly has €440bn, only about 57 per cent of that is...really available for potential borrowers, if it is to maintain a triple A" After euro-support for Ireland is paid out, then you might have drawings by Portugal, and then, who knows when Spanish bank recapitalisation is necessary?
So I say, late in the second quarter. After the next IMF test. Before I rent a summer place.
US firms warn Irish over tax move
by James Quinn - Telegraph
The Irish government has been given a stark warning from some of the biggest American companies in Ireland on the risk of a mass exodus if the country's low corporation tax rate is raised. The warning – from executives at Microsoft, Hewlett-Packard (HP), Bank of America Merrill Lynch and Intel – spoke of the "damaging impact" on Ireland's "ability to win and retain investment" should the country's corporation tax rate be increased from 12.5pc.
It came as talks between members of the Irish government and the European Union and the International Monetary Fund continued around the clock on a financial aid package of as much as €100bn to shore up the country's beleaguered banking system. Although Brian Lenihan, the Irish finance minister, has indicated Ireland's 12.5pc corporation tax rate – the lowest in the eurozone – will not be raised, a number of factions within the European Union are known to have pushed for it to be increased in return for the bail-out.
Nicholas Sarkozy, the French president, said yesterday that while raising taxes will not be a condition of the bail-out, he expects Ireland to raise its corporation tax rate: "It's obvious that when confronted with a situation like this, there are two levers to use: spending and revenues. I cannot imagine that our Irish friends, in full sovereignty, [would not use] this because they have a greater margin for manoeuvre than others, their taxes being lower than others." The US warning was written by Lionel Alexander, president of the American Chamber of Commerce in Ireland, and a senior HP executive.
Foreign investment equates to €110bn – or 70pc – of all exports with US companies alone employing more than 100,000 workers. While the companies are not threatening to leave at this stage, the statement – signed by senior Irish executives from each of the four companies mentioned – does directly point out that although Ireland's tax rate may be low in European terms, it is not when compared with locations such as Singapore, India and China.
The letter says: "The IMF, the European Central Bank and the European Commission must realise that any increase in our corporation tax rate would ultimately make us more economically dependent, not less so on our European Union partners." Separately, John Herlihy, head of Google's 2,000-strong European headquarters in Dublin, told The Belfast Telegraph that "anything that impinges on Ireland's competitiveness is going to be a big thing for Google".
Writing in today's The Sunday Telegraph, Mohamed A El-Erian, chief executive of PIMCO, the world's largest bond investor, also cautions that the proposed bail-out package may not be enough to shore up Ireland's finances. "Ireland and its official partners must convert a short-term liquidity approach into a more sustainable long-term solution that addresses solvency, growth and economic restructuring," he writes.
The collective warnings came as the Irish government was holding an all-day cabinet meeting today in an attempt to finalise two separate restructuring plans: a four-year plan for the economy, containing €15bn of cuts, and the other on the banking sector itself. The government is expected to publish both on Tuesday after which it is likely to formally request aid from the EU and IMF to support its austerity aims.
It seems the sale of some state assets will be included in the measures. These may include the government's 25pc stake in Aer Lingus, the national carrier, as well as its National Lottery licence and the country's separate gas and electricity boards.
FBI Raids Three Hedge Funds Amid Insider-Trading Case
by Susan Pulliam, Jenny Strasburg And Michael Rothfeld - Wall Street Journal
Federal Bureau of Investigation agents raided the offices of three hedge funds as part of a high-profile insider-trading investigation, and more could be on the way, according to people familiar with the matter.The offices of Diamondback Capital Management LLC and Level Global Investors LP were raided. Both hedge funds are run by former managers of Steven Cohen's SAC Capital Advisors. The third firm raided is Loch Capital Management LLC, based in Boston, people familiar with the matter say.
"The FBI is executing court-authorized search warrants in an ongoing investigation," said Richard Kolko, an FBI spokesman, who declined to comment further. Loch had $750 million in assets as of the start of this year, according to SEC filings. The firm, run by brothers Timothy and Todd McSweeney, didn't immediately return a message seeking comment. Leonard Pierce, a lawyer for Loch Capital, declined to immediately comment.
The McSweeney brothers are acquaintances with Steven Fortuna, a hedge-fund manager who pleaded guilty in the Galleon case and agreed to cooperate in that ongoing investigation. Level Global Investors LP is a Greenwich, Conn., hedge-fund firm run by David Ganek, a former SAC Capital trader and art collector. He started Level Global in 2003 and earlier this year reported managing about $4 billion in assets. Diamondback Capital Management LLC is based in Stamford, Conn., and was started in 2005. It oversees more than $5 billion in assets, according to SEC filings.
The moves by the FBI follow an article by The Wall Street Journal describing an insider-trading investigation that is expected to encompass consultants, investment bankers, hedge-fund and mutual-fund traders. The investigation is said by people close to the situation to eclipse in size and magnitude past insider-trading probes. Messages left with Richard Schimel, Diamondback's co-chief investment officer, and Diamondback's general counsel, Joel Harary, on their office phones weren't immediately returned.
A spokesman for Level Global said, "We can confirm that agents from the Federal Bureau of Investigations visited our offices this morning as part of what we believe to be a broader investigation of the financial services industry discussed in media reports over the weekend. We are cooperating fully with the authorities and, at the same time, we are fully operational and continue to work diligently for the benefit of our investors."
Is Anyone Actually Bothering to Fact-Check the Fed’s Claims?
by Phoenix Capital Research - Zero Hedge
The primary reason Bernanke claims to be engaging in QE at all is to keep interest rates low to sustain the housing market (and allegedly help the economy).
However, even a cursory look at the situation shows he is either lying or somehow manages to monitor the US monetary system WITHOUT actually ever look at price levels. Either one of those options is enough to give you a chill… and illustrate beyond doubt that he is unqualified for the position he holds.
Indeed, were Bailout Ben to bother opening a stockcharts account or looking at Yahoo! Finance occasionally, he’d see that Treasuries actually have FALLEN (pushing interest rates higher) whenever he announced a QE program.
As you can see, back in March 2009, when the first QE program was announced, long-term US debt traded at 130. When QE 1 was announced, long-term US debt levels FELL (pushing interest rates higher), they then traded in a range from 115-122 until April 2010 when QE 1 ended.
The same thing happened with the announced of QE lite and QE 2. Indeed, the only time that Treasuries actually RALLIED (lowering long-term interest rates) was from April-August 2010: the ONLY time that the Fed hasn’t maintained a public QE program in the last 18 months.
Again, how on earth does no one in Congress or elsewhere call Bernanke on this? It’s obvious to ANYONE who bothers looking at US Treasuries that QE fall whenever Bernanke implements QE. Is it really possible that NO ONE in a position of power actually bothers checking on this stuff? I mean, if we’re going to allow the guy to throw TRILLIONS of Dollars around, surely someone should bother engaging in minor fact checking like… or I don’t know, seeing if his claims are actually even VALID.
The same goes for his and president of the Federal Reserve Bank of New York William Dudley claims that QE will help the US unemployment situation. Even according to the BLS’s ridiculous numbers, the unemployment rate when QE 1 started was 8.5% with 13.2 million unemployment, compared to today’s rate of 9.6% with 14.8 million unemployed.
How on earth can anyone with a working brain claim that the $1.25+ trillion we’ve already spent on QE was helpful to employment when both the RATE and the actual NUMBER of unemployed Americans have risen dramatically since QE was first implemented?
In plain terms, the only way Bernanke’s claims regarding QE’s success are valid is if you present the argument that both interest rates and unemployment would have been a whole lot worse without QE. That’s a pretty piss poor argument for spending nearly $2 trillion.
After all, if you’re going to resort to abstractions when it comes to justifying spending INSANE amounts of money, there’s literally no end to the craziness you can come up with. According to this logic, the Fed could literally print $2 trillion and give it to Wall Street and claim that it helped the economy when it fact it did nothing but return Wall Street bonuses to 2007 levels.
Oh wait… it already did that.
Flawed Mortgage Papers May Pose Economic Risk
by Gretchen Morgenson - New York Times
Kudos to the Congressional Oversight Panel for publishing a thoughtful and thorough report last week on the mortgage documentation mess. It argued that, yes, in fact, these paperwork problems may have significant implications for banks, investors and the stability of the financial system.
Since mortgage paperwork flaws became front-page news this fall, the banks caught in the glare have characterized the problems as technicalities that are easily remedied. Their responses sound a lot like Mike Wazowski, the assistant scarer in "Monsters, Inc.," who is reprimanded for not turning in his daily reports. "Oh, that darn paperwork," he tells his supervisor. "Wouldn’t it be easier if it all just ... blew away?"
But the mortgage paperwork problems aren’t blowing away, and the panel report analyzes their implications in fine detail. It also questions the view, held by some overseeing the Treasury Department’s loan modification effort, that mortgage documentation errors have no impact on the program.
Phyllis Caldwell, chief of the Treasury’s Homeownership Preservation Office, articulated the Treasury’s view in her testimony before the panel, according to the report. She said false affidavits and other processing flaws weren’t problematic for the government’s modification plan, known as the Home Affordable Modification Program or HAMP. Because loan modifications don’t require physical production of a mortgage and note, the Treasury has not been examining whether document flaws have an impact on its efforts, she said.
Ted Kaufman, the former Delaware senator who leads the panel, saw it differently on Thursday. "Financial institutions all say everything is fine, but prudence would dictate that we make sure," he said. "Not that we don’t trust the banks, but let’s take a hard look at this thing."
In an interview on Friday, Tim Massad, acting assistant Treasury secretary for financial stability, clarified his agency’s position. "We weren’t saying these problems aren’t serious," he said. "They are extremely serious, they are clearly widespread, they do pose dangers and they need to be fixed. But based on the evidence today, we didn’t see a systemic risk to financial stability."
Still, the oversight report points out problems that arise if servicers modify mortgages under HAMP when they don’t actually have the right to do so. First, the report said, borrowers may either be granted or denied modifications improperly. And paperwork errors may mean the government is paying modification bounties of $1,500 a mortgage to the wrong banks.
Treasury officials told the oversight panel that if ownership of the mortgage was not properly transferred, the government could claw back incentives paid to the wrong institution. But such a solution may not be feasible, the report concluded. And even if the Treasury chased down a loan servicer to return the incentive money it received in error, the government would have essentially handed that bank an interest-free loan for the period it kept the funds. Given the size and the ambitions of HAMP, all of these problems loom large. As of October, the program had generated about 520,000 active permanent loan modifications.
The report also said a lack of concern at the Treasury over paperwork flaws might lead borrowers to conclude that HAMP traffics in double standards. After all, borrowers have to provide reams of documents before receiving a modification — even though servicers don’t have to prove ownership of the note underlying a property, the report said.
But the meat of the report comes in its analysis of the threats that false loan documentation may pose to banks’ balance sheets and to financial stability in the broader economy. These perils are related to the possibility that banks will have to buy back loans from investors if they were based on false documentation, or if the proper records required when setting up mortgage securities trusts were not kept, the report said. "There are scenarios whereby wholesale title and legal documentation problems for the bulk of outstanding mortgages could create significant instability in the marketplace," the report stated.
Litigation from investors in mortgage-backed securities is likely, the report concluded. "Claimants will contend that the securitization trusts created securities that were based on mortgages which they did not own," the report said. "Since the nation’s largest banks often created these securitization trusts or originated the mortgages in the pool, in a worst-case scenario it is possible that these institutions would be forced to repurchase the M.B.S. the trusts issued, often at a significant loss."
Consider a lawsuit in the United States Bankruptcy Court in Camden, N.J. It involves a Countrywide loan and a note that was supposed to have been deposited in a mortgage pool issued by the lender in 2006.
In an opinion published last Tuesday, the chief judge, Judith H. Wizmur, cited testimony from an executive at Bank of America, which bought Countrywide. The lender’s practice, the executive said, was "to maintain possession of the original note and related loan documents." Countrywide did this even though the pooling and servicing agreement governing the mortgage pool that supposedly held the note required that it be delivered to the trustee, the court document shows.
If Countrywide’s practice was to hold onto the note, then investors in this pool and others may question whether the security was constructed properly and legally and may be able to require Bank of America to buy back their securities. Larry Platt, a partner at the law firm K & L Gates in Washington, spoke on behalf of Bank of America on Friday. He said the New Jersey decision did not constitute a basis for broad mortgage repurchase requests.
"We believe the loan was sold to the trust even if there wasn’t an actual delivery of the note," he said. "The risk of repurchase is going to depend on the unenforceability of the loan and we think the loan is enforceable. We think this is an aberration; Countrywide’s practice was to deliver the notes." While it is hard to assess the damage that suits like these could cause, the authors of the Congressional report estimated $52 billion.
The bulk of that would be shouldered largely by the four largest banks — Bank of America, JPMorgan Chase, Citigroup and Wells Fargo. The panel arrived at this estimate using analysis provided by investment firms and taking into account possible loan losses, an assessment of successful put-back rates and assumptions of losses to be borne by the banks on mortgages they are forced to repurchase.
Those banks have already reserved almost $10 billion for expenses related to buybacks, in addition to $11.4 billion in costs they have already incurred, the report said. "It is not inconceivable that the major banks could recognize future losses over a 2-3 year period," it said.
Only time will tell if the panel’s estimates are low, high or right on the money. The report is painstakingly temperate. But financial burdens for big banks are not all that’s at stake here. Perhaps even more significant are the social costs associated with mortgage paperwork improprieties and any attempt to brush them under the rug.
"If the public gains the impression that the government is providing concessions to large banks in order to ensure the smooth processing of foreclosures," the report contends, "the people’s fundamental faith in due process could suffer." And along with it, their faith in the government.
US banks face $100-$150 billion Basel III shortfall
by Brooke Masters and Justin Baer - Financial Times
The top 35 US banks will be short of between $100bn and $150bn in equity capital after the new Basel III global bank regulations are imposed, with 90 per cent of the shortfall concentrated in the biggest six banks, according to Barclays Capital. The BarCap study assumes the banks will need to hold top-quality capital equal to 8 per cent of their total assets, adjusted for risk.
This 8 per cent tier one capital ratio, a key measure of bank strength, provides a one point cushion against falling below the effective global minimum of 7 per cent set in September by the Basel Committee on Banking Supervision. The Basel III reforms will hit banks in two ways – by gradually tightening the definition of what counts as tier one capital; and by forcing banks to increase the risk adjustment for big swathes of their businesses.
Banks can respond by increasing their capital through retained earnings or equity issuance or they can cut their risk-weighted assets through sell-offs and by cutting back on risky business lines. So far most analysts believe the big US banks will not be forced to raise capital just for regulatory purposes. But some people worry sharp cuts in assets could force banks to curb lending to the real economy or raise borrowing costs.
"These shortfalls are entirely manageable. The more difficult question is what affect the new rules will have on the cost and availability of credit and bank profitability," said Tom McGuire, head of the Capital Advisory Group at BarCap. He estimates that US banks can cut their equity needs by $10bn with every $125bn reduction in risk-weighted assets. Analysts say it is hard to predict the impact of the reforms on US banks because they have to apply Basel III risk-weighted asset changes as well as an earlier Basel II set of rules that European banks have been following for years.
Analysts at CLSA, an arm of Credit Agricole, estimate the 14 biggest US global and regional banks will need a total of $41bn to achieve the same 8 per cent tier one ratio, if both the Basel II and III changes are included. "It’s extremely difficult and there’s more reliance on company forecasts than I’m normally comfortable with. While these are the best numbers we can publish, we recognise a degree of uncertainty" said Mike Mayo, US banks analyst.
Neal Wolin, US deputy Treasury secretary, said this week, "US banks have gotten out front on these issues in a very impressive way and are world leading in terms of preparing themselves for this new world." BarCap also projects that the 35 US banks will need to come up with another $500bn in cash and easy-to-sell assets to meet new Basel liquidity requirements that take effect in 2015. But the needs are not evenly distributed – only two-thirds of the banks have any shortfall at all.
Fed Sees 4.25 Million More Foreclosures Through 2012
by Vivien Chen - Bloomberg
The Federal Reserve expects about 4.25 million more foreclosure filings through 2012, and problems with the home-seizure process may threaten the U.S. housing and economic recovery, Fed Governor Elizabeth Duke said in prepared testimony. "In the end, an overhang of homes awaiting foreclosure is unhealthy for the housing market and can delay its recovery, as well as that of the broader economy," she said in remarks that will be presented to a congressional subcommittee tomorrow. A copy of Duke’s testimony was posted on the U.S. House of Representatives website.
A report released yesterday by a Congressional Oversight Panel found that irregularities in the foreclosure process may undermine financial stability. Attorneys general in all 50 states opened an investigation last month into whether banks and loan servicers used faulty documents or improper practices to seize homes.
U.S. regulators, including the Fed, expect to complete the on-site stage of their review into foreclosure practices this year and plan to publish their findings in early 2011, Duke said. The Fed estimates that the U.S. will have about 2.25 million residential foreclosure filings this year, and again next year, followed by 2 million more in 2012, she added in the statement to the Subcommittee on Housing and Community Opportunity.
"Financial institutions face a number of risks if inadequate controls result in faulty foreclosure documents or failure to follow legal procedures," Duke said. "We are gathering information to ensure that the institutions we supervise have adequately assessed these risks and have accounted for them properly." The Fed’s "forceful" response to the financial crisis over the past two years, including its purchase of mortgage- backed securities, has reduced mortgage rates and made home loans more affordable, she said.
Speak softly and carry a big chainsaw
Last week Asia, this week Europe: no wonder Barack Obama has been to so many foreign summits since his party took a pounding in the mid-term elections. With the prospect of gridlock at home, a president naturally turns abroad. Yet Mr Obama badly needs to show that he can still lead on domestic policy. He should start by cajoling Congress into an agreement to tackle America’s ominous fiscal arithmetic.
Conventional wisdom says such an agreement is impossible: the problem is too big, the politics too difficult. But it is wrong to suppose that the deficit is unfixable, as two proposals for fixing it have shown this month. And even the politics may not be totally intractable.
The scale of America’s fiscal problem depends on how far ahead you look. Today’s deficit, running at 9% of GDP, is huge. Federal debt held by the public has shot up to 62% of GDP, the highest it has been in over 50 years. But that is largely thanks to the economy’s woes. If growth recovers, the hole left by years of serial tax-cutting and overspending can be plugged: you need to find spending cuts or tax increases equal only to 2% of GDP to stabilise federal debt by 2015. But look farther ahead and a much bigger gap appears, as an ageing population needs ever more pensions and health care. Such "entitlements" will double the federal debt by 2027; and the number keeps on rising after then. The figures for state and local debt are scary too.
The solution should start with an agreement between Mr Obama and Congress on a target for a manageable level of publicly held federal debt: say, 60% of GDP by 2020. They should also agree on the broad balance between lower spending and higher taxes to achieve this. This newspaper believes that the lion’s share of the adjustment should come on the spending side. Entitlements are at the root of the problem and need to be trimmed, and research has shown that although spending cuts weigh on growth in the short run, they hurt less than higher taxes. And in the long run later retirement and other reforms will expand the labour force and thus potential output, whereas higher taxes dull incentives to work and invest.
Yet even to believers in small government, like this newspaper, there are good reasons for letting taxes take at least some of the strain. Politically, this will surely be the price of any bipartisan agreement. Economically, there is sensible room for manoeuvre without damaging growth. American taxes are relatively low after the reductions of recent years. In an ideal world the tax burden would be gradually shifted from income to consumption (including a carbon tax). But that is politically hard—and there is a much easier target for reform.
America’s tax system is riddled with exemptions, deductions and credits that feed an industry of advisers but sap economic energy. Simply scrapping these distortions—in other words, broadening the base of taxation without any new taxes—could bring in some $1 trillion a year. Even though some of this would have to go in lowering marginal rates, it is a little like finding money behind the sofa cushions. The tax system would be simpler, fairer and more efficient. All this means that America can sensibly aim for a balance between spending cuts and higher taxes similar to the benchmark set by Britain’s coalition government. A ratio of 75:25 is about right.
There is legitimate concern that, done hastily, austerity could derail a weak recovery. But this strengthens the case for a credible deficit-reduction plan. By reassuring markets that America will control its debt, the government will have more scope to boost the economy in the short term if need be—for instance by temporarily extending the Bush tax cuts.
Mr Obama and the Republicans are brimming with ideas for freezing discretionary spending, which covers most government operations from defence to national parks. They have found common cause in attacking "earmarks", the pet projects that lawmakers insert into bills. But discretionary outlays, including defence, are less than 40% of the total budget. Entitlements, in particular Social Security (pensions) and Medicare and Medicaid (health care for the elderly and the poor), represent the bulk of spending and even more of spending growth.
On pensions, the solution is clear if unpopular: people will need to work longer. America should index the retirement age to longevity and make the benefit formula for upper-income workers less generous. The ceiling on the related payroll tax should be increased to cover 90% of earnings, from 86% now.
Health-care spending is a much tougher issue, because it is being fed by both the ageing of the population and rising per-person demand for services. Richer beneficiaries should pay more of their share of Medicare, while the generosity of the system should be kept in check by the independent panel set up under Mr Obama’s health reform to monitor services and payments. The simplest way for the federal government to restrain Medicaid would be to end the current system of matching state spending and replace this with block grants, which would give the states an incentive to focus on cost-control.
Chainsaw you can believe in
Devising a plan that reduces the deficit, and eventually the debt, to a manageable size is relatively easy. Getting politicians to agree to it is a different thing. The bitter divide between the parties means that politicians pay a high price for consorting with the enemy. So Democrats cling to entitlements, and Republicans live in fear of losing their next party nomination to a tea-party activist if they bend on taxes. Even the president’s own bipartisan commission can’t agree on what to do.
But true leaders turn the hard into the possible. Two things should prompt Mr Obama. First, the politics of fiscal truth may be less awful than he imagines. Ronald Reagan and Bill Clinton both won second terms after trimming entitlements or raising taxes. Polls in other countries suggest that nowadays tough love can sell. Second, in the long term economics will tell: unless it changes course, America is heading for a bust. If Mr Obama lacks the guts even to start tackling the problem, then ever more Americans, this paper and even those foreign summiteers will get ever more frustrated with him.
U.S. nearing end of major Wall Street insider-trading probe
by Zachary A. Goldfarb and Jerry Markon - Washington Post
Federal prosecutors in New York are in the advanced stages of an extensive insider-trading investigation that could lead to criminal charges against Wall Street traders and executives, federal law enforcement officials said Saturday. Authorities had been preparing to file charges in the probe within weeks, but that timetable could be accelerated after an article about the investigation appeared in the Wall Street Journal on Saturday, the officials said.
The investigation, conducted by the U.S. Attorney's Office in Manhattan and the FBI, has been underway for several years and extends far beyond Wall Street to financial offices across the country, the paper reported. Officials would not discuss specific companies or individuals under scrutiny or provide further details. The Securities and Exchange Commission is conducting a parallel civil probe, officials said.
The Journal reported that authorities are investigating bankers at Goldman Sachs in particular who may have given confidential information about health-care mergers to certain investors. Goldman is the top provider of investment banking services in health-care deals. A Goldman spokesman declined to comment.
The Journal also said that prosecutors are examining consultants with industry expertise who may be providing confidential information to hedge funds and mutual funds. It reported that one subject of the investigation is Primary Global Research, a Mountain View, Calif., firm. Chief executive Unni Narayanan said in an interview: "We have no insight into what the government is investigating. All we know is Primary Global Research is not a target."
Federal authorities, including U.S. attorneys and the FBI, have been pouring resources into investigating what one senior federal law enforcement official called "rampant" illegal insider trading. Officials say they are up against new challenges in detecting, investigating and prosecuting abuses given the speed and complexity of the financial markets and a burst of new electronic media over which traders can communicate.
Preet Bharara, U.S. attorney for the Southern District of New York, has led the charge on insider trading investigations, calling the area a "top criminal priority" and embracing new, controversial tools such as wiretaps to investigate potential abuses. Last year, Bharara joined the SEC in filing the largest insider trading case in history against Raj Rajaratnam, founder of the Galleon Group hedge fund, and a host of associates. Rajaratnam has maintained his innocence and is fighting the charges in court. More than 20 people have been charged in the investigation.
"Illegal insider trading is rampant and may even be on the rise," Bharara said in a speech last month to the New York City Bar Association. But he cautioned: "It has perhaps never been more difficult to attack through traditional investigative means." Bharara said the challenges include the innovations that allow stock trading at such high speeds and in such high volume that it can be difficult to pinpoint specific transactions completed with the advantage of inside information.
He said the growth in the number of financial newsletters, Web sites, blogs and social media outlets "publishing every last rumor and report of potential mergers and acquisitions and earnings reports" has made it easier for those accused of insider trading to claim they acted on the basis of something they read. Bharara also defended the use of wiretaps to investigate insider trading cases.
In the Galleon case, Rajaratnam's lawyers have argued that their use should be reserved for especially severe types of criminal cases - such as narcotics and terrorism - and that prosecutors acted improperly in obtaining a judge's approval for a wiretap. Another judge is weighing whether to allow prosecutors to use the wiretaps as evidence in the case against Rajaratnam.
"Some have asked, why use court-authorized wiretaps in insider trading cases?" Bharara said in the speech. "The quick answer is that every legitimate tool should be at our disposal - especially where, as in the case of insider trading, an essential element of the crime is a communication. It does not take a rocket scientist to understand that it would be helpful to have the actual recording of the communication."
Prosecutors and the SEC have been pressing other insider trading cases recently, too. Earlier this month, prosecutors in Manhattan charged a French doctor with providing illegal inside information to a hedge fund manager about a drug undergoing review. Last month, former Countrywide chief executive Angelo Mozilo agreed to settle insider trading and other charges brought by the SEC for $67.5 million. About $22.5 million of that amount is being paid by Mozilo; the rest is being covered by Bank of America, which acquired Countrywide.
Goldman In Insider Trading Probe?
by Matt Taibbi - Rolling Stone
News leaked out today that the feds will soon be herding a whole pen full of Wall Street firms into court on insider trading charges, including, reportedly, our old friends Goldman, Sachs. The basic charge here is that investment banks and other firms were leaking insider info about things like mergers to closely-allied hedge funds, who in turn placed the requisite bets on or against the companies in question.
The most interesting detail in the WSJ piece, to me, was a bit about an email sent by one John Kinnucan, a principal at an Oregon-based company called Broadband Research, to a number of his clients. The email reads, in part, as follows:trading on copious inside information… (They obviously have been recording my cell phone conversations for quite some time, with what motivation I have no idea.) We obviously beg to differ, so have therefore declined the young gentleman's gracious offer to wear a wire and therefore ensnare you in their devious web."
Aside from the amusing detail here in which Kinnucan brags about turning down an offer to cooperate with the feds (I ain't no stinking rat!) the thing to note here is the list of clients he sent this email to. Those include hedge-fund firms SAC Capital Advisors LP and Citadel Asset Management, and mutual-fund firms Janus Capital Group, Wellington Management Co. and MFS Investment Management.
Those are some interesting MF-ing names. Citadel and SAC, along with Goldman and David Einhorn's Greenlight Capital, were among the firms subpoenaed by Lehman Brothers lawyers after that latter firm exploded in 2008. The allegation then was that a number of hedge firms worked with banks and other companies to spread rumors about Lehman at the same time some of those funds were holding big short positions.
Similar allegations, involving many of the same players, were made after Bear Stearns was blown apart in March of that year. There were multiple storylines in the that business, including one set of allegations that some hedge funds with short positions in Bear leaked information about Bear having a liquidity problem during that fateful week in March of 2008.
Another extremely interesting detail, which I and others have reported on, involves the fact that all the big banks on Wall Street (including Goldman) and many of hedge funds (including Citadel) had a meeting at the Fed with Ben Bernanke just three days before the Fed announced its plan to subsidize the sale of Bear to JP Morgan Chase. This was on March 11, 2008; the only big bank that was not invited to this meeting was Bear, Stearns. It strains all credulity to imagine that the rescue of Bear was not discussed at that meeting and that none of the players at that meeting made moves based on those conversations.
The other crimes on Wall Street have been so pervasive and so massive in scope in the past decade or so that good old-fashioned insider trading — hedge funds and other gamblers robbing the great mass of uninformed investors by acting on exclusive intelligence not available to the rest of us — seems almost quaint. Compared to a situation in which the entire economy was based on fraud schemes like the mass sales of mismarked AAA-rated mortgage-backed assets, worrying about hedge-fund gamblers skimming a few billion here and there off of insider info seems almost misguided.
However there is a mounting pile of evidence suggesting a sort of widespread culture of insider trading in which a few players (specifically the major banks and a few of the biggest and best-connected hedge funds) have milked a seemingly endless stream of exclusive information, not occasionally or opportunistically but as an ongoing commercial strategy. I get about two or three letters a week from people in the finance business complaining that this or that company is openly advance-trading on a) information from the Federal Reserve about things like interest rate changes, or b) info about big client orders in things like commodities, or c) mergers and the like.
Certainly there is a great deal to be suspicious of with regard to the behavior of certain companies in advance of major events like the rescue of Bear Stearns, the collapse of Lehman Brothers, the AIG bailout, the acquisition of Merrill Lynch by Bank of America, the emergency conversions to bank holding company status of Goldman and Morgan Stanley, and the announcement of major bailout programs like the TALF and the P-PIP.
Anyone who knew in advance how or when these deals were going down could make billions almost without trying, and we know that the heads of many of the major banks were in contact with key federal officials during this entire period. So there's that.
That's why it'll be interesting to see how far this federal probe goes. Many of the people I talk to insist that the insider-trading problem is a pervasive, systemic issue, not something that is isolated and limited to a few bad apples. So it'll be interesting to see if the Justice Department has a less indulgent view of insider crime than, say, Ben Bernanke's Federal Reserve. Not that I'm holding my breath for a huge roundup, but boy, wouldn't it be something if they aimed as high as this thing probably goes?
FCIC Delays Report Despite Republican Opposition, Citing 'Very Powerful Interests' Seeking To Undermine Investigations
by Shahien Nasiripour - Huffington Post
The bipartisan panel created to investigate the roots of the financial crisis voted Wednesday to delay the Dec. 15 publication of their report despite Republican opposition, foreshadowing disagreements that are sure to arise when the commission attempts to reach a consensus on the causes of the worst financial crisis since the Great Depression.
The Financial Crisis Inquiry Commission's 6-to-3 vote came after the panel's four Republicans argued privately against the decision to ignore the statutory deadline set by Congress. One of the Republicans, former Congressional Budget Office Director Douglas Holtz-Eakin, was unable to participate in the vote, though he made his dissent known. The report will now be released in January.
The move comes on the heels of revelations that the nation's biggest mortgage companies employed possibly-fraudulent tactics in trying to foreclose on distressed homeowners. The recent disclosures by the likes of Bank of America, JPMorgan Chase and Ally Financial that they used flawed documentation practices sparked inquiries by all 50 state attorneys general, as well as federal prosecutors and federal regulators, among others. Those investigations are ongoing.
The crisis commission is also looking into the matter, said Phil Angelides, the panel's Democratic chairman. The Republicans on the panel are resisting further inquiries, according to people familiar with the matter. Angelides said in an interview that "there are very powerful interests" seeking to undermine the panel's investigation. "People who have trillions of dollars at stake who have been watching our efforts closely," Angelides said. "There have been efforts throughout the year to undermine me and my fellow commissioners."
Among other things, Angelides' panel is probing the documentation practices that federal watchdogs say may be emblematic of the entire mortgage securitization chain, in which lenders may have used bogus documents when originating mortgages and passed them through to other entities before they were sold to investors, ignoring basic due diligence along the way. The discovery of the use of "robo-signers" -- employees whose sole job was to rubber-stamp documents without actually reading them or verifying their contents -- "may have concealed much deeper problems in the mortgage market," the Congressional Oversight Panel reported Tuesday.
Large lenders and Wall Street banks may be on the hook for hundreds of billions of dollars in unexpected losses, threatening to undermine "the very financial stability that the Troubled Asset Relief Program was designed to protect," the COP report noted.
The information the crisis commission has gathered from its numerous public hearings has added fuel to that fire. During an April hearing, the panel heard from Richard Bowen, former chief underwriter for Citigroup's consumer-lending unit, who said he discovered in mid-2006 that more than 60 percent of mortgages the bank bought from other firms and sold to investors were "defective." Investors were not informed, however.
In September, the former president of the nation's leading home-loan due-diligence firm testified that as many as 28 percent of mortgages given to borrowers with poor credit that the firm examined for Wall Street banks failed to meet basic underwriting standards, and that nearly half of them were likely sold to investors anyway. Keith Johnson, formerly of Clayton Holdings, said he was unaware of any disclosure to unwitting investors by the banks.
Together, the testimony and accompanying data could bolster pension funds and other investors in their pursuit to force Wall Street banks to buy back the bogus mortgages they peddled. Investors are trying to use the rights prescribed in the agreements from their initial purchases of the mortgage-linked securities.
Analysts from Compass Point Research and Trading LLC pegged potential losses for 11 global banks to reach $179.2 billion, the Washington-based firm said in an Aug. 17 report.
The crisis panel, though, was expected to be wrapping up its report on the crisis. The law that created the commission says: "On December 15, 2010, the commission shall submit to the President and to the Congress a report containing the findings and conclusions of the commission on the causes of the current financial and economic crisis in the United States."
In a statement, the four Republicans on the panel -- Holtz-Eakin, Vice Chairman Bill Thomas, Keith Hennessey and Peter Wallison -- said that the commission is "statutorily required to deliver the report on December 15." They added that the panel "has had over a year to complete the report" and that the delay was due to a need to "accommodate the publication of a book-length document."
The FCIC hopes to publish a book on its findings, similar to the national best-seller that came from the work of the 9/11 Commission. The crisis panel recently switched publishers.
The law allows the panel an additional 60 days "for the purpose of concluding the activities of the commission ... and disseminating the final report." It's under that additional 60-day authority that Angelides and his fellow Democrats are using to justify their delay by up to six weeks. The panel's authority formally ends Feb. 13.
To date, the commission has interviewed more than 700 people, examined hundreds of thousands of documents and held 19 days of public hearings, Angelides wrote in a Wednesday letter to President Barack Obama.
In an interview, Angelides said his team of investigators continue to pursue leads in their "ongoing investigation." He added that they're also interviewing new witnesses, in addition to circling back to old ones, indicating that the panel continues to push its investigation further. Congress tasked the panel to deliver its findings on 22 distinct areas, ranging from monetary policy to accounting rules and international capital flows. They also include the role of "fraud and abuse in the financial sector, including fraud and abuse towards consumers in the mortgage sector"; "lending practices and securitization"; and "the quality of due diligence undertaken by financial institutions."
All three of those areas would seem to include the current mortgage and foreclosure documentation issues roiling big banks and the financial sector. However, there may be complications in trying to advance its investigation. Because the law says that the commission's findings must be sent to the President by Dec. 15, there are open questions regarding the validity of further investigative actions beyond that date, including issuing subpoenas, people familiar with the crisis panel's efforts said. For example, a firm may have grounds to resist the subpoena, these people said.
Hennessey wrote that a vote to delay the report "would violate the law, or at a minimum would be inconsistent with the law," according to a post on his blog. "The FCIC is a creation of a law, and we must be governed by that law whether we commissioners like it or not," he wrote. The crisis panel isn't the first to unilaterally delay the release of its congressionally-mandated report. The Commission on the Prevention of Weapons of Mass Destruction Proliferation and Terrorism blew past its deadline, as did the National Bipartisan Commission on the Future of Medicare and the Commission on Affordable Housing and Health Care Facility Needs in the 21st Century.
Those panels, however, didn't have subpoena authority. And their reports were largely advisory. The FCIC can make criminal referrals to the Department of Justice. Like the FCIC, the 9/11 Commission also had substantial powers, and it, too, extended its own deadline. However, the 9/11 panel got its extension from an act of Congress. Angelides said the extra time will be critical for the panel's investigation and subsequent report.
In a statement, the spokesman for Senate Banking Committee Chairman Christopher Dodd said the Connecticut Democrat supports the panel's investigation, and was not opposed to the report's delay. Dodd indicated that a "brief delay to allow the commission to finalize and prepare a more thorough report was not unreasonable," spokesman Sean Oblack wrote in an email.
There Will Be Blood
by Paul Krugman - New York Times
Former Senator Alan Simpson is a Very Serious Person. He must be — after all, President Obama appointed him as co-chairman of a special commission on deficit reduction.
So here’s what the very serious Mr. Simpson said on Friday: "I can’t wait for the blood bath in April. ... When debt limit time comes, they’re going to look around and say, ‘What in the hell do we do now? We’ve got guys who will not approve the debt limit extension unless we give ’em a piece of meat, real meat,’", meaning spending cuts. "And boy, the blood bath will be extraordinary," he continued.
Think of Mr. Simpson’s blood lust as one more piece of evidence that our nation is in much worse shape, much closer to a political breakdown, than most people realize.
Some explanation: There’s a legal limit to federal debt, which must be raised periodically if the government keeps running deficits; the limit will be reached again this spring. And since nobody, not even the hawkiest of deficit hawks, thinks the budget can be balanced immediately, the debt limit must be raised to avoid a government shutdown. But Republicans will probably try to blackmail the president into policy concessions by, in effect, holding the government hostage; they’ve done it before.
Now, you might think that the prospect of this kind of standoff, which might deny many Americans essential services, wreak havoc in financial markets and undermine America’s role in the world, would worry all men of good will. But no, Mr. Simpson "can’t wait." And he’s what passes, these days, for a reasonable Republican.
The fact is that one of our two great political parties has made it clear that it has no interest in making America governable, unless it’s doing the governing. And that party now controls one house of Congress, which means that the country will not, in fact, be governable without that party’s cooperation — cooperation that won’t be forthcoming.
Elite opinion has been slow to recognize this reality. Thus on the same day that Mr. Simpson rejoiced in the prospect of chaos, Ben Bernanke, the Federal Reserve chairman, appealed for help in confronting mass unemployment. He asked for "a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits."
My immediate thought was, why not ask for a pony, too? After all, the G.O.P. isn’t interested in helping the economy as long as a Democrat is in the White House. Indeed, far from being willing to help Mr. Bernanke’s efforts, Republicans are trying to bully the Fed itself into giving up completely on trying to reduce unemployment.
And on matters fiscal, the G.O.P. program is to do almost exactly the opposite of what Mr. Bernanke called for. On one side, Republicans oppose just about everything that might reduce structural deficits: they demand that the Bush tax cuts be made permanent while demagoguing efforts to limit the rise in Medicare costs, which are essential to any attempts to get the budget under control. On the other, the G.O.P. opposes anything that might help sustain demand in a depressed economy — even aid to small businesses, which the party claims to love.
Right now, in particular, Republicans are blocking an extension of unemployment benefits — an action that will both cause immense hardship and drain purchasing power from an already sputtering economy. But there’s no point appealing to the better angels of their nature; America just doesn’t work that way anymore.
And opposition for the sake of opposition isn’t limited to economic policy. Politics, they used to tell us, stops at the water’s edge — but that was then. These days, national security experts are tearing their hair out over the decision of Senate Republicans to block a desperately needed new strategic arms treaty. And everyone knows that these Republicans oppose the treaty, not because of legitimate objections, but simply because it’s an Obama administration initiative; if sabotaging the president endangers the nation, so be it.
How does this end? Mr. Obama is still talking about bipartisan outreach, and maybe if he caves in sufficiently he can avoid a federal shutdown this spring. But any respite would be only temporary; again, the G.O.P. is just not interested in helping a Democrat govern. My sense is that most Americans still don’t understand this reality. They still imagine that when push comes to shove, our politicians will come together to do what’s necessary. But that was another country.
It’s hard to see how this situation is resolved without a major crisis of some kind. Mr. Simpson may or may not get the blood bath he craves this April, but there will be blood sooner or later. And we can only hope that the nation that emerges from that blood bath is still one we recognize.
Debt and Taxes: Will Washington Ever Grow Up?
by Peter Coy and Heidi Przybyla - Businessweek
In the space of a week, the chiefs of two blue-ribbon panels in Washington have put forth tough-minded proposals for reining in federal budget deficits. The ugly reality that they emphasized—no less true for being so often described or so reliably ignored—is that Americans have undersaved, overspent, and made unaffordable commitments for the future, particularly on retiree health care. The IOUs are accumulating, and if nothing is done soon, the chits will hit the fan: Creditors will stop lending money or at least demand much higher interest rates for it, as they already have in Greece, Ireland, and Iceland.
Each deficit-reduction proposal was full of serious ideas, and each was greeted by immediate and deadly sniper fire from both sides of the aisle. Postponing action is irresistible because the political blowback from doing anything meaningful is scorching. Every interest group is passionately committed to defending its own sacred cow, trampling the concept of sharing the pain for the common good. Washington, it appears, still isn't ready to grow up.
Those ringing the deficit alarm tend to be old and indignant. Peter G. Peterson, the 84-year-old retired banker, invested $1 billion in a foundation focused on fixing budget deficits, foreign debt, and entitlement spending. He ruminates about the morality of a society that leaves a legacy of debt. "I have nine grandchildren," Peterson says. "I think a lot about them." Alan K. Simpson is 79. The former Republican senator from Wyoming, who is co-chairman of President Obama's bipartisan National Commission on Fiscal Responsibility and Reform, told Bloomberg Television's Charlie Rose on Nov. 16 that he was too old to play budgetary politics anymore.
"We're not going to sign our names at this stage of life to a bunch of pap," Simpson says he told his co-chairman, Democrat Erskine Bowles, 65, the North Carolina businessman who served as White House Chief of Staff for Bill Clinton. Says Simpson: "We call it the cruelty of making promises you can't keep."
Simpson and Bowles issued the first deficit-reduction proposal on Nov. 10, one week before former White House budget director Alice M. Rivlin, a 79-year-old Democrat, and Pete V. Domenici, 78, the former Republican senator from New Mexico, unveiled the recommendations of the Bipartisan Policy Center commission that they co-chair. With old-timey affection, she calls him "Senator Pete"; he calls her "Doctor Alice." But their admonitions are grim. Letting deficits continue to run out of control, they warn, would "make us increasingly vulnerable to the dictates of our creditors, including nations whose interests may differ from ours."
Simpson and Bowles proposed to shrink or kill the sacrosanct income-tax deduction for home mortgage interest; slash $100 billion in defense spending, in part by closing bases; freeze the pay of federal workers, excluding combat forces, for three years; raise the gasoline tax by 15¢ a gallon; cut Medicare reimbursements to doctors, hospitals, and drug companies; shore up Social Security with tax hikes and benefit cuts; and sharply curtail the growth of federal health expenditures. Rivlin and Domenici rely more on increasing revenue to balance the budget. They call for a 6.5 percent national sales tax, which they package for public consumption as a "Debt Reduction Sales Tax."
Among Democrats, House Speaker Nancy Pelosi almost instantly labeled the plan of the Obama commission co-chairmen "simply unacceptable." On the Republican side, Americans for Tax Reform gravely warned that "support for the commission chair plan would be a violation of the Taxpayer Protection Pledge which over 235 congressmen and 41 senators have made to their constituents."
The fact is, it's impossible to balance the budget without infuriating the followers of both Pelosi, who will lose the Speaker's chair in January, and Grover Norquist, the single-minded president of Americans for Tax Reform. The U.S. can't put its house in order without deep spending cuts and revenue increases.
Consider first the case of the antitax purists: To meet the commission's goal of reducing the deficit to 2.2 percent of gross domestic product by 2015 yet not raise taxes, lawmakers would have to find $98 billion in spending cuts beyond those in the Simpson-Bowles plan. Getting all the action on the spending side would be painful, especially if it's from discretionary spending rather than entitlements. Defense cuts in the plan are already steep. Defense Secretary Robert Gates on Nov. 16 said he's willing to take some reductions but called the Simpson-Bowles plan "math, not strategy."
Wiping out the entire Justice Dept., including all federal prosecutors, the FBI, and the U.S. Drug Enforcement Administration (projected 2015 budget: $32 billion), would get the GOP less than a third of the way to the Simpson-Bowles target. Eliminating the entire food stamp program in addition ($66 billion) would pretty much close the gap, but at the expense of an epidemic of malnutrition. Another option would be to eliminate the Energy Dept. ($28 billion), Interior ($12 billion), and unemployment insurance ($48 billion).
Paul Ryan, the Wisconsin Republican who is the next House Budget Committee chairman, says the GOP has no intention of stopping critical government functions, adding, "there are a lot of ways for government to be cut." True, but how deeply? "If you want to do it all on the spending side under current law you'd have to constrain spending so it doesn't grow at all for the entire decade," says Gene Steuerle, a senior fellow at the Urban Institute in Washington.
The Democrats are equally unrealistic in attempting to shield completely the entitlement programs such as Medicare, Medicaid, and Social Security that represent about 40 percent of federal spending. The task quickly becomes impossible as the baby boomer generation retires. Representative Jan Schakowsky, an Illinois Democrat who sits on Obama's deficit-reduction panel, on Nov. 16 released a plan for the short term that includes an increase in taxes of $275 billion by 2015. Even a tax hike that large doesn't suffice past 2015, when boomer retirements start to kick in. "We haven't figured that all out yet," Schakowsky acknowledges.
One fat revenue target for the Democrats would be ending most income-tax deductions. The Simpson-Bowles plan offers three options on taxes, including a "zero option" that would fully wipe away the more than 300 tax deductions, credits, exclusions, and other breaks subsidizing everything from health care to housing. But those deductions and credits are immensely popular. The elimination of mortgage-interest deductions alone "would be a huge capital loss for anybody currently owning a home because people would not be willing to pay as much for houses," says Roberton Williams, a senior fellow at the Washington-based Urban Institute. The change "would drive prices down substantially," Williams says.
O.K., but if Democrats leave the deductions and credits alone, where will the money come from? Raising income tax rates on the wealthy is a Democratic favorite. But the Democrats would have to hike taxes on more than just the wealthy. Even if lawmakers ratcheted up the top two tax rates to an unthinkable 91 percent and 86 percent, from the current 35 percent and 33 percent, the government would still show a deficit totaling roughly $500 billion by 2019, according to researchers at the Washington-based Tax Policy Center, a project of the Urban Institute and Brookings Institution think tanks. "You end up with ridiculous marginal tax rates," said Donald Marron, the center's director. "It's just not feasible."
Balancing the budget isn't just an accounting exercise. It's about setting national priorities, weighing competing concepts of fairness, and creating incentives to promote growth. Cutting the budget in a way that simply off-loads costs onto states, localities, businesses, or families doesn't do Americans as a group any good. It's taking money out of one pocket and putting it in another. The benefits come when spending and taxation policies induce greater efficiency, and when they stimulate investment for future prosperity as opposed to consumption.
To its credit, the Simpson-Bowles plan would fix some of the "misincentives" buried in the nightmarish Internal Revenue code. All three of the proposal's tax options would subject more of Americans' income to taxation. That would make it possible to raise the same amount of money with lower rates, or raise more money without raising rates. That's a good thing. Lower rates on the last dollar of income earned encourage people to work and save more money, which in the long run is the least painful way to balance the budget. The knee-jerk rejection of the Simpson-Bowles tax ideas by some GOP activists is hard to understand: Cutting marginal tax rates is precisely the type of reform that free-market economists favor.
Democrats who howled that the Simpson-Bowles plan was stacked against the poor were also mistaken, according to a preliminary analysis by the Tax Policy Center. The center studied a variant of the plan that gets rid of the home mortgage deduction but keeps the child credit and the earned income tax credit for low-income workers. That variant is worse for the rich than extending the Bush tax cuts in their entirety. The top 1 in 1,000 families by income would see aftertax income fall by 7.8 percent, more than any other income tier, according to the group's analysis.
What's really scary is that as painful as their prescriptions are, neither Simpson-Bowles nor Rivlin-Domenici is assured of bringing the budget into long-term balance. What's causing the long-term numbers to go kerflooey: Medicare and Medicaid. Both panels assert that the government will reduce the annual growth of its health-care spending to one percentage point above the growth of economic output, vs. predicted growth of GDP plus 1.7 percent.
Vaguely, Simpson and Bowles say that will happen "by establishing a process to regularly evaluate cost growth, and tak[ing] additional steps as needed if projected savings do not materialize." That's more an aspiration than a plan, sounding like Steve Martin's joke about how to become a millionaire and not pay taxes: First, get a million dollars. Then, don't pay taxes. The Rivlin-Domenici plan would convert Medicare from a defined-benefit plan into a defined-contribution plan, like a health-care 401(k), but there's no guarantee that doing so would slow its cost growth.
Here's the depressing math. Boston University economist Laurence Kotlikoff, an expert in generational accounting, calculates using Congressional Budget Office data that the U.S. faces a fiscal gap of about $200 trillion. That's the shortfall between the expected inflows and expected outflows of the federal government in perpetuity, based on current policy and discounted back into today's dollars. (The ideal fiscal gap is zero dollars, by the way, so we're more than a little off.)
By Kotlikoff's back-of-the-envelope calculation, which he presented in a column for Bloomberg News on Nov. 15, the Simpson-Bowles plan would reduce the fiscal gap to about $30 trillion. Still huge, but much better. However, if the deficit cutters' hand-waving over health-care costs fails and noninterest spending continues to rise after 2020 at the rates projected by the Congressional Budget Office, Kotlikoff estimates a fiscal gap of about $150 trillion under the plan—too high for even the world's biggest economy to sustain. Says Kotlikoff: "It's miles short of what's needed."
The political deadlock in Washington is making matters worse. In their willingness to reach across the aisle, "Doctor Alice" Rivlin and "Senator Pete" Domenici are anachronisms. From the 1950s through the 1970s, the ideologies of the Democratic and Republican parties overlapped—each was a big tent sheltering politicians with a wide range of viewpoints. Bipartisanship didn't always promote budget discipline: Democrats went along with Republicans' big defense budgets, for example, while Republicans acquiesced to Democrats' social spending. Today's political polarization doesn't seem to be good for budget-balancing, either. The latest election drove the parties further apart by casting out many Blue Dogs, the centrist Democrats who sometimes bridged the two parties' differences.
Is there any hope? Peterson is staking a billion dollars that the answer is yes. His foundation's latest public-awareness campaign features a Presidential candidate, Hugh Jidette ("huge debt"), whose motto is "borrow like there's no tomorrow." Corny, yes. But as Peterson observes: "Someone once said that the job of the public is often to make it safe for the politicians to do the right thing." In other words, Washington won't grow up until America does.
The Blur Between Spending and Taxes
by N. Gregory Mankiw - New York Times
Should the government cut spending or raise taxes to deal with its long-term fiscal imbalance? As President Obama’s deficit commission rolls out its final report in the coming weeks, this issue will most likely divide the political right and left. But, in many ways, the question is the wrong one. The distinction between spending and taxation is often murky and sometimes meaningless.
Imagine that there is some activity — say, snipe hunting — that members of Congress want to encourage. Senator Porkbelly proposes a government subsidy. "America needs more snipe hunters," he says. "I propose that every time an American bags a snipe, the federal government should pay him or her $100." "No, no," says Congressman Blowhard. "The Porkbelly plan would increase the size of an already bloated government. Let’s instead reduce the burden of taxation. I propose that every time an American tracks down a snipe, the hunter should get a $100 credit to reduce his or her tax liabilities."
To be sure, government accountants may treat the Porkbelly and Blowhard plans differently. They would likely deem the subsidy to be a spending increase and the credit to be a tax cut. Moreover, the rhetoric of the two politicians about spending and taxes may appeal to different political bases.
But it hardly takes an economic genius to see how little difference there is between the two plans. Both policies enrich the nation’s snipe hunters. And because the government must balance its books, at least in the long run, the gains of the snipe hunters must come at the cost of higher taxes or lower government benefits for the rest of us.
Economists call the Blowhard plan a "tax expenditure." The tax code is filled with them — although not yet one for snipe hunting. Every time a politician promises a "targeted tax cut," he or she is probably offering up a form of government spending in disguise.
Erskine B. Bowles and Alan K. Simpson, the chairmen of President Obama’s deficit reduction commission, have taken at hard look at these tax expenditures — and they don’t like what they see. In their draft proposal, released earlier this month, they proposed doing away with tax expenditures, which together cost the Treasury over $1 trillion a year.
Such a drastic step would allow Mr. Bowles and Mr. Simpson to move the budget toward fiscal sustainability, while simultaneously reducing all income tax rates. Under their plan, the top tax rate would fall to 23 percent from the 35 percent in today’s law (and the 39.6 percent currently advocated by Democratic leadership).
This approach has long been the basic recipe for tax reform. By broadening the tax base and lowering tax rates, we can increase government revenue and distort incentives less. That should command widespread applause across the ideological spectrum. Unfortunately, the reaction has been less enthusiastic.
Pundits on the left are suspicious of any plan that reduces marginal tax rates on the rich.
But, as Mr. Bowles and Mr. Simpson point out, tax expenditures disproportionately benefit those at the top of the economic ladder. According to their figures, tax expenditures increase the after-tax income of those in the bottom quintile by about 6 percent. Those in the top 1 percent of the income distribution enjoy about twice that gain. Progressives who are concerned about the gap between rich and poor should be eager to scale back tax expenditures.
Pundits on the right, meanwhile, are suspicious of anything that increases government revenue. But they should recognize that tax expenditures are best viewed as a hidden form of spending. If we eliminate tax expenditures and reduce marginal tax rates, as Mr. Bowles and Mr. Simpson propose, we are essentially doing what economic conservatives have long advocated: cutting spending and taxes.
Yet another political problem is that each tax expenditure has its own political constituency. If Congressman Blowhard ever got his way, the snipe hunters of the world would surely fight to keep their tax break. One major tax expenditure that the Bowles-Simpson plan would curtail or eliminate is the mortgage interest deduction. Without doubt, many homeowners and the real estate industry will object. But they won’t have the merits on their side.
This subsidy to homeownership is neither economically efficient nor particularly equitable. Economists have long pointed out that tax subsidies to housing, together with the high taxes on corporations, cause too much of the economy’s capital stock to be tied up in residential structures and too little in corporate capital. This misallocation of resources results in lower productivity and reduced real wages. Moreover, there is nothing particularly ignoble about renting that deserves the scorn of the tax code. But let’s face it: subsidizing homeowners is the same as penalizing renters. In the end, someone has to pick up the tab.
There are certain tax expenditures that I like. My personal favorite is the deduction for charitable giving. It encourages philanthropy and, thus, private rather than governmental solutions to society’s problems. But I know that solving the long-term fiscal problem won’t be easy. Everyone will have to give a little, and perhaps even more than a little. I am willing to give up my favorite tax expenditure if everyone else is willing to give up theirs.
The Bowles-Simpson proposal is not perfect, but it is far better than the status quo. The question ahead is whether we can get Senator Porkbelly and Congressman Blowhard to agree.
N. Gregory Mankiw is a professor of economics at Harvard.
India Microcredit Faces Collapse From Defaults
by Lydia Polgreen and Vikas Bajaj - New York Times
India’s rapidly growing private microcredit industry faces imminent collapse as almost all borrowers in one of India’s largest states have stopped repaying their loans, egged on by politicians who accuse the industry of earning outsize profits on the backs of the poor.
The crisis has been building for weeks, but has now reached a critical stage. Indian banks, which put up about 80 percent of the money that the companies lent to poor consumers, are increasingly worried that after surviving the global financial crisis mostly unscathed, they could now face serious losses. Indian banks have about $4 billion tied up in the industry, banking officials say. "We are extremely worried about our exposure to the microfinance sector," said Sunand K. Mitra, a senior executive at Axis Bank, speaking Tuesday on a panel at the India Economic Summit.
The region’s crisis is likely to reverberate around the globe. Initially the work of nonprofit groups, the tiny loans to the poor known as microcredit once seemed a promising path out of poverty for millions. In recent years, foundations, venture capitalists and the World Bank have used India as a petri dish for similar for-profit "social enterprises" that seek to make money while filling a social need. Like-minded industries have sprung up in Africa, Latin America and other parts of Asia.
But microfinance in pursuit of profits has led some microcredit companies around the world to extend loans to poor villagers at exorbitant interest rates and without enough regard for their ability to repay. Some companies have more than doubled their revenues annually. Now some Indian officials fear that microfinance could become India’s version of the United States’ subprime mortgage debacle, in which the seemingly noble idea of extending home ownership to low-income households threatened to collapse the global banking system because of a reckless, grow-at-any-cost strategy.
Responding to public anger over abuses in the microcredit industry — and growing reports of suicides among people unable to pay mounting debts — legislators in the state of Andhra Pradesh last month passed a stringent new law restricting how the companies can lend and collect money. Even as the new legislation was being passed, local leaders urged people to renege on their loans, and repayments on nearly $2 billion in loans in the state have virtually ceased. Lenders say that less than 10 percent of borrowers have made payments in the past couple of weeks.
If the trend continues, the industry faces collapse in a state where more than a third of its borrowers live. Lenders are also having trouble making new loans in other states, because banks have slowed lending to them as fears about defaults have grown.
Government officials in the state say they had little choice but to act, and point to women like Durgamma Dappu, a widowed laborer from this impoverished village who took a loan from a private microfinance company because she wanted to build a house. She had never had a bank account or earned a regular salary but was given a $200 loan anyway, which she struggled to repay. So she took another from a different company, then another, until she was nearly $2,000 in debt. In September she fled her village, leaving her family little choice but to forfeit her tiny plot of land, and her dreams.
"These institutions are using quite coercive methods to collect," said V. Vasant Kumar, the state’s minister for rural development. "They aren’t looking at sustainability or ensuring the money is going to income-generating activities. They are just making money." Reddy Subrahmanyam, a senior official who helped write the Andhra Pradesh legislation, accuses microfinance companies of making "hyperprofits off the poor," and said the industry had become no better than the widely despised village loan sharks it was intended to replace. "The money lender lives in the community," he said. "At least you can burn down his house. With these companies, it is loot and scoot."
Indeed, some of the anger appears to have been fueled by the recent initial public offering of shares by SKS Microfinance, India’s largest for-profit microlender, backed by famous investors like George Soros and Vinod Khosla, a co-founder of Sun Microsystems. SKS and its shareholders raised more than $350 million on the stock market in August. Its revenue and profits have grown around 100 percent annually in recent years. This year, Vikram Akula, chairman of SKS Microfinance, privately sold shares worth about $13 million.
He defended the industry’s record before the India Economic Summit meeting, saying that a few rogue operators may have given improper loans, but that the industry was too important to fail. "Microfinance has made a tremendous contribution to inclusive growth," he said. Destroying microfinance, he said, would result in "nothing less than financial apartheid."
Indian microfinance companies have some of the world’s lowest interest rates for small loans. Mr. Akula said that his company had reduced its interest rate by six percentage points, to 24 percent, in the past several years as volume had brought down expenses. Unlike other officials in his industry, Vijay Mahajan, the chairman of Basix, an organization that provides loans and other services to the poor, acknowledged that many lenders grew too fast and lent too aggressively. Investments by private equity firms and the prospect of a stock market listing drove firms to increase lending as fast as they could, he said.
"In their quest to grow," he said, "they kept piling on more loans in the same geographies." He added, "That led to more indebtedness, and in some cases it led to suicides." Still, he said, the number of borrowers who are struggling to pay off their debts is much smaller than officials have asserted. He estimates that 20 percent have borrowed more than they can afford and that just 1 percent are in serious trouble.
One of India’s leading social workers, Ela Bhatt, who heads the Self-Employed Women’s Association, or SEWA, said microfinance firms had lost sight of the fact that the poor needed more than loans to be successful entrepreneurs. They need business and financial advice as well, she said. "They were more concerned about growth — not growth of the livelihoods and economic status of the clients, but only the institutions’ growth," she said.
Mr. Mahajan, who is also the chairman of the Microfinance Institutions Network, said that the industry was now planning to create a fund to help restructure the loans of the 20 percent of borrowers in Andhra Pradesh who were struggling. He also said the industry, which has been reluctant to accept outside help, would share its client databases with the government and was negotiating restrictions on retail lending that did not go through the nonprofit self-help lending groups.
The collapse of the industry could have severe consequences for borrowers, who may be forced to resort to money lenders once again. It is tough to find a household in this village in an impoverished district of Andhra Pradesh that is not deeply in debt to a for-profit microfinance company. K. Shivamma, a 38-year-old farmer, said she took her first loan hoping to reverse several years of crop failure brought on by drought. "When you take the loan they say, ‘Don’t worry, it is easy to pay back,’ " Ms. Shivamma said.
The man from Share, the company that made her first loan, did not ask about her income, Ms. Shivamma said. She soon ran into trouble paying back the $400 loan, and took out another loan, and then another. Now she owes nearly $2,000 and has no idea how she will repay it. The television, the mobile phone and the two buffaloes she bought with one loan were sold long ago. "I know it is a vicious circle," she said. "But there is no choice but to go on."