July 16 2011: The Real State of US Housing

Frances Benjamin Johnston Spring House 1944
"Spring house, Hill Plantation. Washington vicinity, Wilkes County, Georgia"

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Ilargi: The more the ratings agencies come under fire for downgrading, the more they do just that -or so it seems-: downgrade (or threaten to). While it may seem strange that they still have credibility left after being late on just about any call they've made in ages, don't let's forget that they are very much part of the political and banking system, and therefore fully engaged in extend and pretend policies. It's still funny that the EU cries foul over Fitch, a company that boasts 60% French ownership.

Perhaps it would be even better if the ratings agencies start rating European banks for real. The stress tests certainly don't do that. All you really need to know about those tests is in this one line from Harry Wilson and Philip Aldrick at the Telegraph:

European banks set for 'chaos Monday' after nine fail stress test

While Greek bonds are trading at about half their face value in the market, the EBA only required banks to assume a 15% loss on their holdings.

Ilargi: Maybe they're thinking Greek debt will recover? Not very likely to happen, the yield on Greek 2-year bonds broke over 32% this week. Keep that up for a bit, and Greece is going going gone.

The reality is, we're just watching a bunch of Punch and Judy shows here, stress tests, downgrades, the US debt ceiling "controversy". Obama has now put his job on the line to get a deal done; he must be pretty sure he’ll get one in the end; a job and a deal.

Still, whether it comes to either that potential US downgrade Moody‘s and S&P are threatening, or to the debt ceiling charade, or the stress tests, all of the above are based on entirely the wrong numbers, and I wouldn't be one bit surprised if that is fully intentional: all are meant to hide what's really happening, and where the real hurt lies.

In the end, the US economy -as expressed in the GDP- remains 70% dependent on consumers. And I doubt there's anyone left who would pretend that consumers are doing well, or even getting better. The richest few percent perhaps, but certainly not the majority. This is obvious from all kinds of data, like unemployment, consumer confidence etc., but it's nowhere clearer than in housing. Which, conveniently, seems to have fallen off most radars. Convenient, but also patently ridiculous. So here we go once again, the true shape of US housing -and banking-, seen through the lens of a few recent articles that did offer a look behind the -media- veil:

On June 12, Suzanne Kapner wrote this in the Financial Times:

Concern rises over US mortgage defaults

Mortgages held by US banks are performing far worse than home loans sold to Fannie Mae and Freddie Mac, the government-controlled mortgage finance companies, according to federal data made available to the Financial Times. The Office of the Comptroller of the Currency has never before released the data but is considering adding the information to its monthly mortgage report.

Bank-retained loans would typically be made to higher-risk borrowers and, therefore, tend to have higher default rates than loans sold to or guaranteed by the government. But the rate at which bank-held loans are going delinquent raises questions about whether the banks have properly reserved for future losses.

Nearly 20 per cent of non-government-guaranteed mortgages held by the banks are at least 30 days late or in some stage of foreclosure, compared with 7 per cent for loans held by Fannie Mae and Freddie Mac, now controlled by the federal government, according to the data.

The rate at which borrowers of these bank-held loans are falling behind on payments is second only to mortgages that were packaged by banks into securities and sold to investors. Roughly 30 per cent of borrowers with mortgages in these instruments, known as “private-label” securities, have missed at least two payments, according to Laurie Goodman of Amherst Securities

Ilargi: On June 20, Dan Alpert reacted to Kapner's article in a guest post at The Big Picture:

The Next Crisis in Residential Mortgages – New Data Emerges

[..] lender recoveries of loan principal through the liquidation of foreclosed mortgage collateral has been dismal – averaging between 35% and 40% of loan face amount (taking into consideration both selling price and all costs related to the foreclosure and liquidation) for years now and showing no signs of improving.

With home prices, per the S&P Case Shiller 20-City Index, having fallen 6.2% from the end of Q3 2010 through the end of Q1 2011, and now more than 33% below peak levels in July of 2006, the largest banks in the U.S. are therefore loath to repossess and liquidate defaulted home loan collateral. [..]

Some 20% of bank-held mortgage loans, according to Kapner, are 30-days or more past due, which we read as meaning loans that are about to miss two or more payments. We are very interested in seeing more work from Ms. Kapner on this subject as banks hold nearly $3 trillion of mortgage loans in non-securities form on their books. 20% could be an alarmingly large number relative to existing loan loss provisions if such loans are eventually liquidated at anything near today’s prevailing recovery rates.

Ilargi: US banks have $3 trillion "worth" of non-securitized mortgages on their books. 20% of these loans are in various stages of grave distress ("loans that are about to miss two or more payments"). That made me think of a few graphs, and the text below it, from Chicago real estate man Michael David White at Housingstory.net this past March:




An admittedly crude calculation would seem to indicate that on non-securitized mortgages alone, US banks are at risk for 20% of $3 trillion, or $600 billion. The typical return is 35% to 40% of face value, meaning between $210 billion and $240 billion can be expected to be recovered, and therefore $360 billion to $390 billion to be lost. And that's today's face value. That implies a housing market that doesn't deteriorate any further, and isn't flooded with more of the foreclosed homes, the 3.5 million in inventory and the 6.7 million already delinquent mortgages.




Again, the $600 billion at risk at US banks is just for non-securitized mortgages. We're not taking into account risks US banks carry on other assets, and we're not even mentioning mortgage backed securities and other derivatives, like CDS issued on Greece and other PIIGS members. $600 billion is scary enough all by itself.

Not that you would know it from the banks themselves, or the media, indicates Shanthi Bharatwaj at The Street:

Dividend Bump May be in JPMorgan's Future

U.S. banks are going to have so much extra capital over the 12 months, they are not going to know what to do with it, JPMorgan Chase CEO [Jamie Dimon] said Thursday, signaling investors should expect more dividends and share buybacks from the nation's second largest bank.

Ilargi: Yes, that is just completely weird, having hundreds of billions at serious risk but being flush with cash regardless, but still, come on, why make loan loss provisions when you're not required to by regulators and politicians, and you know when push comes to shove you'll simply be handed more taxpayer money? Oh, the pleasures of being too big to fail...

There are of course multiple reasons (MERS, judges come to mind) why banks don't execute foreclosure proceedings, but non-recognition of losses is certainly one of the big ones. Still, when you see in the graph above that 20-30 times more homes stay in foreclosure than are sold off, and 6.7 million mortgages are delinquent, you need to ask yourself a few questions. Like: what on earth is going on here? What happens when this ship starts leaking and refuses to sail any longer? Who's going to pay the piper then?

And what are the chances that the housing situation will improve? First of all, that's simply not going to happen with the unemployment numbers as we see them today, not even with the embellished ones the US government reports, let alone the more realistic ones that include all Americans with no or too little work.

From the same piece by Michael David White, Spring 2011 Guide of 30 Key Charts to See Before You Buy or Sell Your Home , published March 30,. here's a number of other graphs which make it all a lot clearer, starting off with White's version of the Case/Shiller index until its 2006 peak:




And then the same index, but including the 37% drop since 2006, as well as the projected trendline:




US domestic real estate has lost 37% of an estimated $22 trillion 2006 peak value, or over $8 trillion. More is lost each and every day. This loss has no reason to stop at $10 trillion. Real unemployment is sky high, as is the housing inventory. There is far too much supply and not nearly enough demand. It's not rocket science.

The only "solution" to this problem, only it isn't truly one, is that the US government starts buying up all homes for sale, or maybe even all homes, period. The Bulgaria model: socialized housing for everyone. Well, teh US has been very busy trying to achieve just that:




And the idea that mortgages are less risky these days doesn't float either. The government, through Fannie Mae, Freddie Mac and Ginnie Mae has a larger share of the mortgage market than ever before, at a time when homes are bought with more leverage than ever before. How 'bout them apples?




So once mortgage debt catches up with real home values (let's call it mark to market), and it necessarily must, as you can easily deduct from the next graph, it's the government, and that means the American taxpayers, who will be on the hook for the trillions of dollars in zombie value that has yet to evaporate. Or, actually, we should say, as we have so many times before: the value disappears, but the debt remains.




But those trillions of dollars are not counted when it comes to the debt ceiling, and the government doesn't even carry Fannie and Freddie on its books. Is proper accounting were applied, that ceiling would have to be raised close to $20 trillion, not the paltry $14.5 trillion or so that Congress says it's fighting about.

The sole comfort for Americans is that they're by no means alone. There have been real estate bubbles in many places, and the US doesn't even come close to being the worst, though we must remember that homeownership rates are higher than in many other countries:




One last graph from Michael David White, which brings us back to banks, in this case the Irish ones.




Ireland is in really bad shape. I wouldn't be surprised at all if the EU decides to let it fall, alongside Greece and Portugal, before the year is over.

Ther are many comparisons out there between the Greek debt situation and the fall of Lehman Brothers. I think there's one important difference, albeit one of many: the bond vigilantes were not involved in Lehman, at least not to a similar degree. They're very much there today, and they can smell blood in many corners. Why they would hold back now, I can't fathom.

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Speaking of Ireland, Stoneleigh and I have both been invited there to attend a retreat organized by FEASTA starting tomorrow. If posting becomes a tad spotty during the next week, that's why.

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CDS on U.S. Banks Stubbornly High
by Nicole Hong - Wall Street Journal

The cost of insuring major U.S. banks' debt against default is still nine times as high as it was before the credit crisis, with the cost of credit default swaps for some institutions' bonds at levels normally associated with credit ratings on the edge of "junk."

Analysts and money managers blame several factors for the stubbornly elevated CDS levels—regulatory uncertainty, declining loan volumes and concerns about how much U.S. banks are exposed to Europe's sovereign debt crisis. Some said they believed the CDS market is too bearish, others that robust earnings would bring protection costs down.

Median spreads for CDS on six major U.S. banks—Morgan Stanley, Bank of America Corp., Citigroup Inc., Goldman Sachs Group, J.P. Morgan Chase & Co. and Wells Fargo & Co.—averaged 1.41 percentage points Friday, according to Markit data. This means that it costs an average of $137,000 annually to insure $10 million of debt against default for five years.

Although these spreads have tightened since they peaked at an average of 3.95 percentage points in March 2009, they are still a far cry from their levels before the credit crisis. In January 2007, average CDS spreads at these six banks were only 0.15 percentage point.

Curiously, CDS no longer correlate to credit ratings the way they did before the crisis. Average CDS-implied ratings at U.S. banks were about one notch higher than their Moody's credit ratings before the crisis, but now are three to five notches lower. These six big banks all have solidly investment-grade credit ratings between Aa3 and A3, but four have CDS-implied ratings of Baa3, just one notch above junk bonds.

Analysts and investors are divided on how much to read into this anomaly. "It doesn't mean the companies will lose access to their deposits or to funding markets," said Tony Smith, senior director at Moody's Analytics. "This is just one metric that will capture investor sentiment at the moment."

But Jeffrey Sica, president and chief financial officer at Sica Wealth Management LLC, said he believes U.S. bank bonds to be a "horrendous investment" now, given their anemic growth since the credit crisis. "A lot of buyers are specifically focused on credit ratings as the core criteria for putting a security into a portfolio, so they're looking at credit ratings and implied credit ratings," Mr. Sica said. "Most money managers are going to avoid anything that has a potential of a downgrade."

To be sure, the likelihood of a major U.S. bank actually missing a debt payment is remote, Smith said. Even if CDS spreads were to widen to about 185 basis points--the current level for non-investment-grade CDS—default risk is not high at any of the banks, he said.

U.S. banks have been reporting steadily improved asset quality and lower leverage in 2011, Barclays Capital analyst Jonathan Glionna wrote in a research note. And earnings are rising. Capital One Financial Corp. said Wednesday that its second-quarter profit rose 50%, beating analyst expectations. Also this week, J.P. Morgan reported a 13% jump in second-quarter profit, and Citigroup posted a 24% increase.

Among the six top banks, J.P. Morgan and Wells Fargo have the tightest average CDS spreads: 0.91 and 1.01 percentage points, respectively, on Friday, according to Markit. At the other end, Bank of America and Morgan Stanley have the widest CDS spreads: 1.75 and 1.76 percentage points, respectively.

Bank of America's spreads have been driven wider by recent management changes and litigation concerns; it's not clear yet whether the bank's controversial offer of $8.5 billion to settle claims involving hundreds of billions of dollars worth of soured mortgage-backed securities will be sufficient. Morgan Stanley is also experiencing franchise reorientation and transition, which have left investors cautious, Smith wrote in a research note. Both companies declined to comment.

The direction of CDS spreads will remain unclear until Dodd-Frank reform rules, which will have an enormous impact on derivatives trading and risk hedging at banks, are completed at the end of this year. "What you need for bank spreads to tighten is more certainty," said Scott MacDonald, head of research at Aladdin Capital LLC. "As long as you don't have clarity in litigation, the economy and regulation, spreads relative to other sectors will stay wide."

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European banks set for 'chaos Monday' after nine fail stress test
by Harry Wilson and Philip Aldrick - Telegraph

European banks are set for a day of "chaos" on Monday as investors and analysts derided the latest round of industry stress tests as "inadequate".

The nine banks that failed the European Banking Authority's (EBA) stress tests will have to raise just €2.5bn (£2.2bn) between them to meet their capital shortfall.

City analysts and investors said the criteria used by the EBA were overly optimistic and failed to capture the severity of the current sovereign debt crisis sweeping across the eurozone. "If the European Union could monetise the value of the credibility it has destroyed it would be richest organisation on Earth," said one major credit manager.

The detail provided by the banks is far greater than in last year's stress tests and the fear now is that with so much information fund managers and banks analysts will be able to make their own judgments on how much extra capital will be required by the 90 banks covered by the tests. "I think next week could see chaos. It's clear the tests the EBA has done are inadequate. We now have the weekend to work out what the banks really need," said one analyst at a major European bank.

Andrea Enria, chairman of the EBA, insisted on Friday the tests the organisation had performed were rigorous, though he admitted market conditions had worsened since the criteria were set. "European banks are clearly in a better position to absorb shocks," he said.

In addition to the nine banks that failed, a further 16 others need to strengthen their balance sheets to rebuild confidence in the embattled sector. Britain's lenders received a clean bill of health but five banks in Spain, two in Greece and one in Austria failed the test. Another German bank would have failed but dropped out of the tests due to a dispute over its capital. A further seven Spanish, two Greek, two Portuguese and two German lenders were among the 16 identified as perilously close to danger.

The tests were conducted on lenders in 21 countries to assess whether they could withstand a prolonged recession without suffering such deep losses that their core capital ratios – their reserves against losses – dropped below 5pc. The tests were designed to placate nervous investors and restore investor confidence in the industry. The EBA has already faced criticism for being too soft, particularly because it did not make any allowance for a sovereign debt default – as is now widely expected in Greece. While Greek bonds are trading at about half their face value in the market, the EBA only required banks to assume a 15pc loss on their holdings.

The accusations follow last year's widely-derided tests by the Committee of European Banking Supervisors. Seven banks failed the last set, but all the Irish banks passed. A few months later, Ireland had to nationalise its banking industry as its lenders faced insolvency. Despite the criticism, analysts have welcomed the EBA's insistence on a far higher degree of disclosure than the previous tests.

Spain has already begun taking steps to bolster the five regional savings banks that failed by injecting taxpayer funds, but the EBA has gone further than expected by instructing those banks that nearly failed to take remedial action. Those banks identified, thought to be the 16 with less than 6pc capital under the stress scenario, have just three months to detail how they will bolster their balance sheets and until April to "fully implement" the plans.

The EBA argued its tests were "rigorous", saying the banks would need to provision €200bn in each of 2011 and 2012 – the two-year timeframe under review. The level of provisioning was "equivalent to the loss rates of 2009 repeated in two consecutive years", it said.

However, the EBA revealed it allowed a large degree of discretion for recapitalisation plans. Although the test was applied to 2010 results, any capital raised between January and April this year was admissible, bolstering balance sheets by £50bn. A further £28bn of "existing and future actions" also helped increase overall capital levels.

The EBA said that without the £50bn of capital, 20 of the 90 banks would have failed the stress tests. "The stress tests haven't accurately compared the health of banks", said Alvarez & Marsal, the firm restruturing the estate of defunct US investment bank Lehman Brothers, in one of the first responses to the release of the stress tests. Their comments set the tone of the snap opinion that the tests would fail to comfort the market.

"The perception that the exercise was not tough enough to see many banks fail but just tough enough for a few to fail will prove hard to correct," said analysts at BNP Paribas. "It will be interesting to see what view the markets take on the EBA's findings over the next seven days," added law firm SJ Berwin.

Of the nine banks to fail, five were Spanish savings banks, or cajas. These were: Caja3, CAM, Catalunyacaixa, Pastor and Unnim. Greece was second with two banks: ATE, which had a core Tier 1 capital ratio of -0.8pc; and ATE. One Austrian bank, Volksbanken, failed the test as did one German bank, Helaba, which refused to publish the results of its test after an argument over its use of disallowed form of loss-bearing capital.

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Stress-test message to banks: Prepare for possible Greek default
by Robert Peston - BBC

Probably the most significant announcement by the European Banking Authority after publishing the results of tests of the resilience of European banks - so called stress tests - was not the headline-grabbing one, to wit that eight out of 90 banks had flunked the tests (or nine, if you include the German bank Helaba which walked out of the exam in a huff at the last minute).

The shortage of capital to absorb losses in those banks, 2.5bn euros ($3.5bn; £2.2bn), is a rounding error in the context of the losses that could be foisted on the financial system if there were a chain reaction of further crises within eurozone economies

It was what the EBA had to say about banks that only narrowly passed the tests, and have significant exposure to the state debts of Greece, Ireland and Portugal, that reverberated. The EBA said it recommends that these banks be forced by their respective national regulators to raise additional capital as a protection against possible further losses from loans going bad, with a deadline of 15 October for the formulation of remedial plans and 15 April 2012 for implementation.

Now this matters, because it is the first time that an EU institution has hinted that there is a realistic possibility of default by Greece, Ireland and Portugal. The important point is that the stress tests forced banks to make provision for losses on their loans to distressed nations, such as Greece, from a change in the terms of those loans that would fall short of actual default. But if, as the EBA says, those estimated losses may not be the worst that could happen, the implication is that default is no longer unthinkable.

And the EBA is insisting that plans to cope with such a default have to be drawn up by vulnerable banks within three months. That suggests a restructuring of Greek sovereign debt - which would see a formal reduction in the value of that debt - is a more imminent prospect than official pronouncements by eurozone governments and EU officials would suggest.

As it happens, the stress-test results imply that if a default were confined to Greece, it would be painful for some banks but not devastating for the integrity of the European financial system. The results also suggest that if a reduction in the value of what Greece owes were followed by Ireland and Portugal insisting that they too should be let off some of their debts, the consequential losses would be just about bearable - though there would have to be a fair amount of help for banks from eurozone, especially German, taxpayers.

That said, the end of the wedge would become perilously thin if the tumbling dominoes of sovereign defaults destroyed investors' belief in the ability of Spain and - especially - Italy to honour their financial obligations.

So after what traders described as the scariest week of trading in European debt markets since the creation of the eurozone - with some investors not wishing to touch Italian government debt - it is increasingly clear that a restoration of confidence in the integrity of Europe's currency union probably requires a more comprehensive and far-reaching plan than just sorting out Greece.

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Italian, Spanish, Irish, Portuguese Bonds Decline as Debt Crisis Spreads
by Emma Charlton and Garth Theunissen - Bloomberg

Italian two-year note yields surged the most in over a year, as the nation’s borrowing costs rose at a debt sale and contagion from Greece’s debt crisis spread across the 17-nation euro region.

Yields on notes from Ireland, Portugal and Greece soared to euro-era records, while German bunds advanced for the fifth time in six weeks as Europe’s politicians clashed over how to craft a new rescue plan for Greece involving private bondholders. Spanish and Italian 10-year bonds slumped, sending yields to the most since the euro’s inception in 1999, as borrowing costs rose to a three-year high at a sale of five-year Italian securities. France, Spain and Germany plan to sell debt next week.

“The market isn’t looking at fundamentals, it is just worried about contagion,” said Huw Worthington, a fixed-income strategist at Barclays Capital in London. “There’s been growing infection across most of the euro-region issuers and it’s hard to see what the catalyst is going to be to get confidence back into the markets with all the issuance next week.”

Italy’s two-year yield climbed 75 basis points over the week to 4.26 percent as of 4:40 p.m. in London yesterday. That’s the biggest weekly increase since the five trading days ending May 7, 2010, the week before Europe’s leaders announced a $1 trillion backstop for the euro. Yields on 10-year notes advanced 48 basis points to 5.75 percent. They reached 6.02 percent on July 12, the most since 1997.

Italian Austerity
A market selloff this week that sent Italian stocks sliding and bond yields surging led Prime Minister Silvio Berlusconi to push for the speedy passage of 40 billion euros ($57 billion) in deficit cuts to balance the budget in 2014 in an attempt to shield his country from the crisis.

Ireland’s two-year bonds plunged after Moody’s Investors Service cut the nation to Ba1 from Baa3 on June 12, saying it is likely to need a second bailout. The country’s two-year yields climbed 6.9 percentage points to a record 23.12 percent, while its 10-year bond yields advanced 1.13 percentage points.

Greek 10-year yields climbed 71 basis points over the week, while the nation’s two-year bond yields soared 2.69 percentage points. Fitch Ratings slashed Greece’s credit rating on July 13 to CCC, its lowest grade, and said that a default is a “real possibility.”

Spain’s 10-year bonds dropped, pushing the yield up 39 basis points to 6.06 percent. Spanish debt may continue to fall next week as the nation prepares to auction 5.5 percent securities maturing in 2021 and 2026 on July 21. It will also sell 12- and 18-month bills on July 19.

German government bonds have handed investors a return of 1.9 percent this year, according to indexes compiled by the European Federation of Financial Analysts Societies and Bloomberg, while Italian bonds have lost 2.5 percent. Greece’s debt has dropped 20.33 percent and Spain’s has returned 0.7 percent.

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The AAA bubble
by Tracy Alloway - FT/Alphaville

This, we think, could well be the most important chart in the world right now:

It comes from a new report, issued by the BIS and Basel Committee’s joint forum, on the subject of securitisation incentives. But what it shows has much wider, more current implications.

According to the report, between 1990 and 2006 — the year in which issuance of Asset-Backed Securities (ABS) peaked — assets with the highest credit rating rose from a little over 20 per cent of total rated fixed-income issues to almost 55 per cent. Think about it. More than half of the world’s debt securities were, for all intents and purposes, considered risk-free. In 2006, that was nearly $5,000bn of assets.

The financial crisis had a lot to do with triple-A ratings being slapped on to subprime securities which didn’t warrant them, we know that. The report says between 1990 and 2006 ABS accounted for 64 per cent of the total growth in the amount of AAA-rated fixed income, compared with 27 per cent attributable to the growth in public debt, 2 per cent to corporate and 8 per cent to other products.

But watch what starts happening from 2008 and 2009.

The AAA bubble re-inflates and suddenly sovereign debt becomes the major force driving the world’s triple-A supply. The turmoil of 2008 shunted some investors from ABS into safer sovereign debt, it’s true. But you also had a plethora of incoming bank regulation to purposefully herd investors towards holding more government bonds, plus a glut of central bank liquidity facilities accepting government IOUs as collateral.  Where ABS dissipated, sovereign debt stood in to fill the gap. And more.

It’s one reason why the sovereign crisis is well and truly painful.

It’s a global repricing of risk, again, but one that has the potential for a much larger pop, so to speak.

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Return of the Gold Standard as world order unravels
by Ambrose Evans-Pritchard - Telegraph

As the twin pillars of international monetary system threaten to come tumbling down in unison, gold has reclaimed its ancient status as the anchor of stability. The spot price surged to an all-time high of $1,594 an ounce in London, lifting silver to $39 in its train.

On one side of the Atlantic, the eurozone debt crisis has spread to the countries that may be too big to save - Spain and Italy - though RBS thinks a €3.5 trillion rescue fund would ensure survival of Europe's currency union.

On the other side, the recovery has sputtered out and the printing presses are being oiled again. Brinkmanship between the Congress and the White House over the US debt ceiling has compelled Moody's to warn of a "very small but rising risk" that the world's paramount power may default within two weeks. "The unthinkable is now thinkable," said Ross Norman, director of thebulliondesk.com.

Fed chair Ben Bernanke confessed to Congress that growth has failed to gain traction. "Deflationary risks might re-emerge, implying a need for additional policy support," he said. The bar to QE3 - yet more bond purchases - is even lower than markets had thought. The new intake of hard-money men on the voting committee has not shifted Fed thinking, despite global anger at dollar debasement under QE2.

Fuelling the blaze, the emerging powers of Asia are almost all running uber-loose monetary policies. Most have negative real interest rates that push citizens out of bank accounts and into gold, or property. China is an arch-inflater. Prices are rising at 6.4pc, yet the one-year deposit rate is just 3.5pc. India's central bank is far behind the curve.

"It is very scary: the flight to gold is accelerating at a faster and faster speed," said Peter Hambro, chairman of Britain's biggest pure gold listing Petropavlovsk. "One of the big US banks texted me today to say that if QE3 actually happens, we could see gold at $5,000 and silver at $1,000. I feel terribly sorry for anybody on fixed incomes tied to a fiat currency because they are not going to be able to buy things with that paper money."

China, Russia, Brazil, India, the Mid-East petro-powers have diversified their $7 trillion reserves into euros over the last decade to limit dollar exposure. As Europe's monetary union itself faces an existential crisis, there is no other safe-haven currency able to absorb the flows. The Swiss franc, Canada's loonie, the Aussie, and Korea's won are too small.

"There is no depth of market in these other currencies, so gold is the obvious play," said Neil Mellor from BNY Mellon. Western central banks (though not the US, Germany, or Italy) sold much of their gold at the depths of the bear market a decade ago. The Bank of England wins the booby prize for selling into the bottom at €254 an ounce on Gordon Brown's orders in 1999. But Russia, China, India, the Gulf states, the Philippines, and Kazakhstan have been buying.

China is coy, revealing purchases with a long delay. It has admitted to doubling its gold reserves to 1,054 tonnes or $54bn. This is just a tiny sliver of its $3.2 trillion reserves. China's Chamber of Commerce said this should be raised eightfold to 8,000 tonnes. Xia Bin, an adviser to China's central bank, said in June that the country's reserve strategy needs an "urgent" overhaul. Instead of buying paper IOU's from a prostrate West, China should invest in strategic assets and accumulate gold by "buying the dips".

Step by step, the world is edging towards a revived Gold Standard as it becomes clearer that Japan and the West have reached debt saturation. World Bank chief Robert Zoellick said it was time to "consider employing gold as an international reference point." The Swiss parliament is to hold hearings on a parallel "Gold Franc". Utah has recognised gold as legal tender for tax payments.

A new Gold Standard would probably be based on a variant of the 'Bancor' proposed by Keynes in the late 1940s. This was a basket of 30 commodities intended to be less deflationary than pure gold, which had compounded in the Great Depression. The idea was revived by China's central bank chief Zhou Xiaochuan two years ago as a way of curbing the "credit-based" excess.

Mr Bernanke himself was grilled by Congress this week on the role of gold. Why do people by gold? "As protection against of what we call tail risks: really, really bad outcomes," he replied.
Indeed.

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QE3 Guaranteed to Fail
by John DeFeo - The Street

in
Whether or not the Federal Reserve opts to make more large-scale asset purchases (colloquially referred to as "QE3") remains to be seen -- but I suspect that Ben Bernanke himself is beginning to realize that QE3 is guaranteed to fail.

Bernanke told Congress on Wednesday that the Fed is ready to provide additional monetary stimulus should the U.S. see adverse economic developments. On Thursday, Bernanke qualified his statement, saying that the Fed is "not prepared at this point to take further action."

Let's analyze the situation:

So What Exactly is Quantitative Easing, Anyway?
Quantitative easing is when the United States' central bank, the Federal Reserve, buys U.S. Treasury bonds.

• Treasury bonds are a future obligation of the United States, paid out with Federal Reserve notes (dollars).



• Federal Reserve notes are a current obligation of the United States, redeemable for goods and services.

If the Federal Reserve purchases bonds directly from the United States Treasury, they are exchanging dollars (current obligations) for future obligations. This is inflationary if the amount of obligations (money) is increasing faster that the amount of capital (goods, services, products and ideas).

However -- the Federal Reserve doesn't buy bonds from the Treasury, it buys them from "primary dealers." Primary dealers are a network of banks (including Goldman Sachs, JPMorgan Chase and Citigroup) that are obligated to buy bonds from the U.S. and serve as a trading partner with the Federal Reserve.

The triangular relationship between the U.S. Treasury, Federal Reserve and major banks can be a head-scratcher -- but make no mistake, this relationship is making some people rich (we'll touch on this point later).

Criteria for the [Long Term] Success of Quantitative Easing

1. If banks are facing a liquidity crisis -- and because of this fact -- are unwilling to lend to qualified borrowers.



2. If qualified borrowers want to borrow money -- and most importantly, are willing to invest in entrepreneurial ideas that will provide a return on invested capital.

Quantitative easing could hypothetically improve the U.S. economy, for the long term, if both of the above criteria are met. Unfortunately, this is not the reality of our situation.

Thanks to taxpayer-funded bailouts and the first two rounds of quantitative easing, major U.S. banks are adequately reserved (in other words, they are liquid). The problem lies in point No. 2: Statements from major banks suggests a drought of qualified borrowers.

Creditworthy individuals (however small this segment of the population might be) are not borrowing. We can blame the uncertainty of tax policies, the staggering unemployment figures or the overall fragility of the economy. But at the end of the day, creditworthy individuals aren't borrowing.

The banks don't need further reserves -- the people need confidence. And confidence comes from the leadership, foresight and conviction from our elected officials, not the Federal Reserve.

Is Quantitative Easing Helping Anyone?
Yes, unfortunately.

Quantitative easing is providing major banks with arbitrage opportunities (risk-free trading profits). Goldman Sachs can buy a bond from the Treasury on Monday and sell it to the Federal Reserve on Tuesday (at a profit) -- the blog ZeroHedge has named this game "Flip That Bond."

Quantitative easing is also helping elected officials shirk their duties to the American public -- in a sense, enabling politicians to spend money the country does not have (or make good on promises that should be broken). Forbes' William Baldwin illustrates this concept beautifully.

"The government wants to spend $1,000 it doesn't have. So it sells a bond. The [ultimate] buyer is the Federal Reserve. The Fed pays for the bond with some folding money. The Treasury spends the $1,000 on farm subsidies or whatever.

The Fed makes a show of treating the $1,000 bond as an investment. It collects $40 in interest from the Treasury. But this is a charade. The Fed declares the $40 (after some overhead costs) as profit and sends the profit right back to Treasury. In reality, the interest payment never left the Treasury building.

When the dust settles, this is what has happened. The farmer has $1,000 of cash. The government did not get this cash by collecting taxes. It got the cash by creating it."

Has Quantitative Easing Ever Been Tried Before? If So, Has It Worked?
Yes -- and to the second question, I don't see any evidence it has worked.

In 1961, the Fed embarked on a similar strategy known as "Operation Twist." But Twist was dismissed as a failure by most, while others blamed the lack of efficacy on the small scale of the operation.

Quantitative easing was attempted again -- on a larger scale -- by Japan in 2001. More than a decade later, Japan has not escaped its problems, and Masaaki Shirakawa, governor of the Bank of Japan, stated that if "short-term stimulative policy measures" are the only cure, then "[policy makers] face a risk of writing the wrong policy prescription."

Unfortunately, some prominent U.S. economists (notably, Larry Summers and Paul Krugman) don't view this history as a cautionary tale, instead suggesting that stimulus only fails when enough of it wasn't done. To this point, I wholeheartedly agree with Mike "Mish" Shedlock's statement, "The disgusting state of affairs is that bureaucratic fools in the EU, US and everywhere else, all believe the cure is the same as the disease if only done in big enough size."

What's the Worst Case Scenario for the Economy
The worst-case scenario is that the nation's banks, under political pressure to lend (see Masaaki Shirakawa's statement above), begin making loans to corporations and individuals that are not creditworthy. Of course, this is exactly how the financial crisis came to fruition, and like before, will end in tears for the greater American public.

Is Ben Bernanke the Problem
I do not think Ben Bernanke is evil or stupid (nor do I think he is insane), rather, I prefer to think of him as a kindly-yet-timid doctor prescribing an obese patient antidepressants. The doctor knows that only the patient can solve the patient's problems, but the doctor lacks the courage to tell the patient, "Go on a diet, get some exercise and get the hell out of my office!"

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Europe Makes Rating Agencies Look Good
by Floyd Norris - New York Times

Mortgage securities destroyed the reputations of credit rating agencies. Could sovereign debt restore them?

When the housing market crumbled, the agencies — Moody’s, Standard & Poor’s and Fitch — came across as incompetent, conflict-ridden and craven. They had handed out Triple-A ratings as if they were party favors, based on mathematical models that turned out to be absurdly overoptimistic. They did not do the work to notice that many securities were stuffed with mortgages of far lesser quality than advertised. They were paid for the ratings by those who created the bad securities.

Now the agencies are under attack again, but this time they look noble. If European politicians have their way, the new image could be one of persecuted truth-tellers.

Moody’s has recently led the way in cutting the ratings of European countries to junk status. It followed S.& P. in cutting Greece’s rating, but has led in recent days in cutting first Portugal’s and then Ireland’s. It pointed to the fact that Greece might be allowed to default as a reason to worry about other countries. A reasonable political reaction would be to say that the negative opinions would be proved wrong, and then to take the actions needed to avoid defaults. Unfortunately, Europe has no real idea how to accomplish that.

Instead, Europe has chosen the strategy laid out 90 years ago in a novel by Ring Lardner, in which a father had a ready answer for an unwanted question: “ ‘Shut up,’ he explained.”

“We should ask ourselves,” said Michel Barnier, the European commissioner whose bailiwick includes financial markets, in a speech this week, “whether it is appropriate to allow sovereign ratings on countries which are subject to an internationally agreed program.”

Coming from the man with primary responsibility for policy decisions on rating agencies in Europe, that sounds very much like a threat. He was echoing a suggestion voiced in March by Christine Lagarde, then the French finance minister, after Moody’s downgraded Greek government bonds, already rated below investment grade, to a lower class of junk. “I am personally convinced,” she told an interviewer, “that credit ratings agencies should not intervene and should not grade countries which are working with the European Commission, the International Monetary Fund and the E.C.B.,” the European Central Bank. Ms. Lagarde now runs the I.M.F.

The Moody’s report that so alarmed Ms. Lagarde said, “There is some possibility that private creditors would be expected to bear some losses” in Greek bonds. Now it turns out that the I.M.F. thinks Moody’s was right, according to a staff report issued Wednesday. Over all, the rating agencies have done a decent job on sovereign debt. “All sovereigns that defaulted since 1975 had noninvestment-grade ratings one year ahead of their default,” the I.M.F. reported last year.

The power of the rating agencies grew in recent decades because government regulators often found it easier to incorporate the ratings in other rules. Worried about the credit quality of securities owned by money market funds? Require those securities to have high ratings. Trying to decide how much capital banks need to offset the risk of differing loans? Tie credit rules to ratings.

Now there is general agreement that regulators should stop requiring the use of ratings, and thereby remove any official imprimatur from the agencies. But that is running into resistance from bank regulators and banks, particularly smaller ones, in both Europe and the United States. They don’t want to have to do their own credit research, and say that in some cases it would be too complicated.

In the past, it has not just been perceptions of expertise that caused the agencies’ opinions to seem important. The agencies sometimes were allowed access to confidential corporate information, a practice that should be banned. If they can know something, so should anyone else interested in the security. There is a certain chicken-and-egg question that politicians might consider. Are Europe’s finances a mess because the rating agencies spoke up, or did they speak up because the finances are in disarray? That answer is obvious.

Greece’s prime minister, George Papandreou, rightly said this week that European leaders were guilty of “taking decisions that in the end prove too little, too late, to convince markets.” Of course, Greece’s own inability to collect taxes and control its budget deficit has more than a little to do with the failure to convince markets.

What seems to anger Mr. Barnier the most is that the agencies are messing in areas where international judgment has already been applied. “These states are under international programs,” he told me this week. “These efforts may be jeopardized by ratings coming out of nowhere.” He added, “The problem is one of democracy.” Europe already requires that countries get 12 hours advance notice of any reports, to give them time to argue that facts are incorrect. (Is it conceivable that some finance ministry has used the time to tip off favored traders about what is coming? Yes.)

The European Union is considering lengthening that period to three days. It also has discussed finding ways to punish agencies for “incorrect ratings.”

For better or worse, the rating agencies sometimes have little influence on markets. In 2004, Standard & Poor’s cut Greece’s rating a notch, although it was still investment grade. Among euro countries, S.& P. wrote, “Greece has the weakest public finances, whether measured in terms of debt ratio or budget deficits.” The analysis was hardly prescient — it said being in the euro zone “shields Greece effectively from potential pressures related to the balance-of-payments” — but the caution was ignored by the market. In those days, Greece had to pay virtually the same rate as Germany when it borrowed money.

There is an attitude in Europe, particularly strong in France, that governments know best, particularly in times of stress. I talked to Mr. Barnier after a meeting in New York of the monitoring board that oversees the group that supervises the International Accounting Standards Board. At that meeting, he called for “a better balance” at the I.A.S.B. between the interests of investors and the need for “financial stability.”

European governments are having a great deal of trouble accepting the idea that they could possibly not be deemed creditworthy. But the public infighting within Europe over how far a bailout should go, and whether investors should have to pick up part of the cost, has clearly worried investors. Moody’s cited that in downgrading both Ireland and Portugal to junk status, but of course traders had noticed the fights without any help from rating agencies.

It should be noted that politicians can get a bit overwrought on this side of the Atlantic as well. “Credit rating agencies have no authority to dictate terms to Congress,” Representative Dennis Kucinich, an Ohio Democrat, declared after Moody’s said Wednesday that the current budget impasse could lead to a downgrading of the United States’ rating. “Moody’s and its compatriot S.& P. were a direct cause of the near collapse of the economy of the United States. That industry should be subject to greater oversight, regulation and fundamental overhaul,” he said.

To politicians, markets can be immensely frustrating. They are told the markets demand this or that, only to be told that it turns out the markets want more. Markets can be fickle and unreliable, punishing companies — or countries — for the same things that they seemed to love only months or years before. But telling the rating agencies — or anyone else — to shut up will not accomplish anything. Unless, of course, it enables rating agencies to appear to be successors to the boy in the story of “The Emperor’s New Clothes.” No doubt they would greatly prefer that reputation to the one they now have.

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Obama Eliminates Warren as Consumer Head
by Mike Dorning and Carter Dougherty - Bloomberg

President Barack Obama has chosen a candidate other than Elizabeth Warren as director of the new Consumer Financial Protection Bureau, according to a person briefed on the matter.

The president’s choice is a person who already works at the consumer agency, the person said today. Obama may make the nomination as soon as next week, another person briefed on the administration’s plans said. The people, who spoke on condition of anonymity because the process isn’t public, didn’t give the name of the choice.

Elizabeth Warren, a Harvard professor, was appointed last fall by Obama to set up the consumer bureau until a director was named. Warren previously was head of the congressional watchdog panel overseeing the bank bailout.

Raj Date, a top deputy to Warren at the consumer bureau, was on a short list of candidates to become director, Bloomberg News reported last month, citing a person briefed on the process.

The consumer bureau, which is to begin formal operations on July 21, was established by the 2010 Dodd-Frank financial- regulatory overhaul to fill what lawmakers said was a gap in oversight of products whose abuse contributed to the 2008 credit crisis, including mortgages and credit cards.

The bureau’s director requires confirmation by the Senate. After 44 Republican senators announced in May that they wouldn’t vote to approve any candidate to run the bureau without changes in its structure, analysts said the White House might have to resort to a temporary appointment during a congressional recess. Sixty of the 100 senators are effectively required to vote for a nomination due to procedural rules.

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