Tuesday, September 28, 2010

September 28 2010: A Graphic Peek Into Our Economic Future

National Photo Co. Smoothing the data June 20, 1924
"Mr. Eddie Herren, Potomac Bathing Beach, Washington, D.C. "

Ilargi: As you probably know, I’ve written extensively on the Consumer Metrics Institute and its graphs and data. The CMI is, in my eyes, very useful, and different from others, in that it tracks the behavior and spending habits of consumers, who make up 70% of US GDP, today, and updates its data on a daily basis.

By comparison, the US Bureau of Economic Analysis, which reports on "official" GDP numbers, publishes its findings once a quarter, and then only one full month after a quarter has already expired. In other words: we won’t know what GDP did in the first two weeks of July until early November. This makes CMI a leading indicator vs the lagging BEA.

In late August, I showed what this implies, in the following graph, based on Doug Short’s great graphs, which are in turn based on CMI data. The idea behind it is that if you let the GDP data where they are in a graph, you can shift the CMI ones forward by roughly a quarter. Similarly, the S&P 500 lags the BEA data by about an additional quarter, so it can be shifted backwards about that much.

I use terms like "about" and "roughly" to indicate that what interests me here is not scientific rigor, but exploring and lining up trends. Looking at the data, it was clear that peaks and troughs line up quite strongly, once you allow for those "time-shifts". Not all that crazy a notion, as the CMI itself confirms. More on that later. First, that graph I made in late August:

Inside that yellow ellipse on the right hand side was my "prediction" of US GDP, based on the 91-day trailing CMI Growth Index. And that kept irking me a bit; it seemed a little steep. It took a while to realize what was happening.

I knew the CMI also publishes 183-day and 635-day trailing Growth Indices, but I’d never seen those in a graph. So I contacted the Institute, hoping they could help. Turns out, they could. Actually, they were happy to. The first lines from Rick Davis at CMI were:
Ilargi: Thank you for your coverage of the Consumer Metrics Institute! I have become a devoted fan of your writing -- I aspire to skewering the economic establishment with similar panache.

It’s always easier to talk on that sort of basis, mutual respect. About the graph above, in which I shifted the timing of the data around, Rick says:
I really like the chart you made, complete with the implications that our data has for the GDP. The wild-cards in all of the GDP data are inventory builds, exports and industrial stimuli -- all of which should reverse or soften in the 3rd and 4th quarters. It will be interesting.

Rick graciously agreed to do a graph just for me with all three Growth Indices combined, about which he says:
Attached is the chart I promised which includes all three of the growth indexes that you requested (91-day, 183-day and 365-day). We had never looked at all three of them superimposed upon each other like this before, and I agree with you that the crossing points are interesting.

Before getting to that graph, though, I think it's good to show you another one, made again by Doug Short, because it shows to what extent the 91-day Index already smoothes out the day-to-day data:

And that smoothing was what I expected, and was hoping to find in the combination of all three indices. Found it! Here’s the graph Rick Davis at CMI made for me:

The implications are plain to see: the more time an Index covers, the more the extremes are dulled. Also, there's a time shift happening here as well, in that the more time an Index covers, the later the peaks and troughs appear. Where in the first graph above, GDP data, extrapolated from the 91-day Index, seemed to fall to -5% (averaged out) in the fourth quarter, an average of all 3 Indices would show a less hefty picture.

To bring this into the scenario painted by Doug Short's graphs, and the one at the top that I based on that, here's two more graphs. Please note that since CMI and Doug Short don’t use the same colors for every index, I had to play with those as well in order to combine them. So, in the CMI graph, 91-day is blue, but below it is red. The 183-day is green for CMI, and yellow for me. The 365-day is red at CMI, and light-blue for me. And then there’s an adjustment for horizontal and vertical proportions too.

We can do either one of two things with this. We can allow for the time-shift inherent in the CMI data when positioning them inside Doug Short's GDP graph, like this:

Or we can leave them as CMI itself has allowed for:

This last graph has the advantage of providing more of a glimpse into the future. Granted, this means we're cheating a little here and there, but not nearly enough to dismiss the data offhand. The upshot is that, as mentioned before, the CMI Indices follow consumer behavior on a daily and constantly updated basis. The 91-day Index, which has the least data to rely on, will always show the most volatility, and point forward more than the other two. You choose which one you think is more accurate.

Please note the GDP Q3 and Q4 data (dark green bars), which I this time around based on a guesstimate of the averages of the 3 CMI Indices, not just the 91-day. They are less negative than in the first graph, but still solidly less than zero (-1% in Q3, -3% in Q4). Note also that in the case where we've provided for the time-shift inherent in the graphs, GDP would likely be far more negative than in the case where we don't. For now, I based the projection on the mid-case, the yellow line 183-day Index. Since things have worsened substantially towards the more recent data, my projections are more likely to underestimate the fall than to exaggerate it.

Finally, lest we forget, Doug Short also incorporates the S&P 500 into his CMI graphs. Now, obviously the S&P is updated daily. Somewhat curiously, though, it proves itself to be a quite severely lagging indicator. If you align the peaks and troughs we've been looking at, which are quite pronounced and far too similar in shape to ignore, the S&P runs about 3 months behind the BEA's official US GDP data, which means that it's as much as 6 months behind the 91-day CMI numbers.

And I know people may claim again that The Automatic Earth consistently says that the next big drop in the markets will forecast the next big one in the real economy. How can that be if the data show that the S&P 500 lags American consumer behavior by half a year? Well, it’s not as strange as it may seem. Apart from flagrant manipulation of the stock markets, of which there is more proof than we would ever even care to see, there's another factor in play.

People who invest in stocks have no access to real consumer data. Caveat: they would if they paid attention to the Consumer Metrics Institute numbers, which is precisely why I pay so much attention to them. But because nobody does this, the S&P 500 is not an indicator of now, but of quite a few yesterdays ago. The time lag it has allows for a rising stock market at the same time that unemployment rises (forget the equally lagging U3 9.6% unemployment), and foreclosures surge. It's all just a matter of time, or timing if you will.

If stocks keep on trading at the very low levels they have for months now, it's certainly possible for the Fed or the Treasury or the Plunge Protection Team, or anyone else (HFT?!), to manipulate the data upward. And from what we've seen lately, there's little doubt they'll try. Still, this doesn't really change anything solid, other than the time lags in the graphs we just looked at. The consumer part of the GDP, which is some 70% no matter what, has been showing negative growth for a long time according to the CMI data. And there doesn't seem to be any way, other than divine intervention, that this will not eventually reflect in the GDP and S&P 500 numbers. Again, it's all just a matter of time.

Here we go, adding in the S&P. First "bare":

And then with GDP projections for Q3 and Q4:

Now where do you think, looking at the correlations between the various data, that the S&P is most likely to go in Q4 2010? How about Q1 2011? The Automatic Earth is not here to dole out investment advice, but all the same, does this look to you like a good time to buy stocks? Sure, there will always remain questions about the above until we see the actual numbers. But by the same token, we're way beyond crystal balls and tea leaves here; the Consumer Metrics Institute are not exactly a bunch of empty coneheads.

And besides, you won't know what really happened until 3-4 months after it did happen. And that, certainly in the case of such relatively powerful swings as we’ve been contemplating, will probably be too late for you to change course.

Simple as that, really. Feel lucky?

US Income Gap Widens: Census Finds Record Gap Between Rich And Poor
by Hope Yen - Huffington Post

The income gap between the richest and poorest Americans grew last year to its widest amount on record as young adults and children in particular struggled to stay afloat in the recession. The top-earning 20 percent of Americans – those making more than $100,000 each year – received 49.4 percent of all income generated in the U.S., compared with the 3.4 percent earned by those below the poverty line, according to newly released census figures. That ratio of 14.5-to-1 was an increase from 13.6 in 2008 and nearly double a low of 7.69 in 1968.

A different measure, the international Gini index, found U.S. income inequality at its highest level since the Census Bureau began tracking household income in 1967. The U.S. also has the greatest disparity among Western industrialized nations. At the top, the wealthiest 5 percent of Americans, who earn more than $180,000, added slightly to their annual incomes last year, census data show. Families at the $50,000 median level slipped lower.

"Income inequality is rising, and if we took into account tax data, it would be even more," said Timothy Smeeding, a University of Wisconsin-Madison professor who specializes in poverty. "More than other countries, we have a very unequal income distribution where compensation goes to the top in a winner-takes-all economy."

Lower-skilled adults ages 18 to 34 had the largest jumps in poverty last year as employers kept or hired older workers for the dwindling jobs available, Smeeding said. The declining economic fortunes have caused many unemployed young Americans to double-up in housing with parents, friends and loved ones, with potential problems for the labor market if they don't get needed training for future jobs, he said.

Rea Hederman Jr., a senior policy analyst at The Heritage Foundation, a conservative think tank, agreed that census data show families of all income levels had tepid earnings in 2009, with poorer Americans taking a larger hit. "It's certainly going to take a while for people to recover," he said. The findings are part of a broad array of U.S. census data being released this month that highlight the far-reaching impact of the recent economic meltdown. The effects have ranged from near-historic declines in U.S. mobility and birth rates to delayed marriage and the first drop in the number of illegal immigrants in two decades.

The census figures also come amid heated political debate in the run-up to the Nov. 2 elections over whether Congress should extend expiring Bush-era tax cuts. President Barack Obama wants to extend the tax cuts for individuals making less than $200,000 and joint filers making less than $250,000; Republicans are pushing for tax cuts for everyone, including wealthy Americans.

The 2009 census tabulations, which are based on pre-tax income and exclude capital gains, are adjusted for household size where data are available. Prior analyses of after-tax income made by the wealthiest 1 percent compared to middle- and low-income Americans have also pointed to a widening inequality gap, but only reflect U.S. data as of 2007.
Among the 2009 findings:
  • The poorest poor are at record highs. The share of Americans below half the poverty line – $10,977 for a family of four – rose from 5.7 percent in 2008 to 6.3 percent. It was the highest level since the government began tracking that group in 1975.
  • The poverty gap between young and old has doubled since 2000, due partly to the strength of Social Security in helping buoy Americans 65 and over. Child poverty is now 21 percent compared with 9 percent for older Americans. In 2000, when child poverty was at 16 percent, elderly poverty stood at 10 percent.
  • Safety nets are helping fill health gaps. The percentage of children covered by government-sponsored health insurance such as Medicaid and the Children's Health Insurance Program jumped to 37 percent, or 27.6 million, from 24 percent in 2000. That helped offset steady losses in employer-sponsored insurance.

The 2009 poverty level was set at $21,954 for a family of four, based on an official government calculation that includes only cash income. It excludes noncash aid such as food stamps.

Arloc Sherman, a senior researcher at the left-leaning Center on Budget and Policy Priorities, noted the effects of expanded government programs in cushioning the impact of skyrocketing unemployment. For example, the Census Bureau estimates that 3.6 million people would have been lifted above the poverty line if food stamps were counted – a number that would have reduced the 2009 poverty rate from the official 14.3 percent to 13.2 percent.

Sheldon Danziger, a University of Michigan public policy professor, said while the U.S. has developed policies to combat poverty, it has trouble addressing ever-widening income inequality – even with a growing federal deficit and previous warnings by former Federal Reserve Chairman Alan Greenspan about soaring executive pay. An Associated Press-GfK Poll this month found that by 54 percent to 44 percent, most Americans support raising taxes on the highest U.S. earners. Still, many congressional Democrats have expressed wariness about provoking the 44 percent minority so close to Election Day.

"We're pretty good about not talking about income inequality," Danziger said.

Local Taxes Roil US Mid-Term Elections
by John D. Mckinnon - Wall Street Journal

A recent rise in state and local taxes is roiling voters in an already tumultuous year, complicating the debate over whether to extend Bush-era tax cuts and upending some campaigns. As Washington is consumed with the debate over whether to extend Bush-era tax cuts beyond the end of the year, voters in many parts of the country are focused on state tax increases already hitting them.

In fiscal 2010, states raised taxes by the largest amount since at least 1979, according to the National Governors Association, a bipartisan group that represents the country's governors, with 29 states increasing taxes by about $24 billion. The rise was reflected in Census Bureau data out Monday, showing that state and local tax collections rose in the second quarter, partly because of tax increases and also due to some improvement in the economy.

This on-the-ground reality is affecting midterm-election campaigns—particularly for aspiring Congressmen coming out of state government—and is further threatening Democrats' plans to end some Bush cuts. Some candidates, under attack from Republican rivals, have already broken with the party's leadership, which wants to let the top two rates return to their higher, Clinton-era levels.

Republicans say increases in tax rates—if the Bush break expires, the top rate would rise from the current 35% to 39.6%—would further stifle investment and hiring. They focus on cutting spending instead. Amid the economic weakness of the last few years, overall tax collections have generally fallen in the U.S. Even the recent increase was well below pre-recession levels. But a pattern of tax and fee increases has confounded this picture, as state and local governments, which generally must balance their budgets each year, have scrambled to patch big fiscal holes.

At least 10 states have raised income-tax rates, at least temporarily, on higher earners in recent years. California created a special top bracket of 10.55% for people making more than $1 million, according to the Tax Foundation, a research group. Oregon created two new top rates, for people making more than $125,000 and more than $250,000. New York, New Jersey and Connecticut all raised rates for higher earners.

Coupled with hikes in local tax rates in many places, such state increases mean that overall taxation levels for some top earners would be higher than they were in the Clinton era if the Bush cuts were to expire. Some states have also increased sales and business taxes. Colorado and Washington expanded their sales taxes to candy and soda, and Colorado began taxing restaurant takeout containers. New York recently raised its cigarette tax to $4.35 a pack, the nation's highest, up from $2.75 last year.

More than two years into the slowdown, some say voters might have reached a tipping point. The 2010 state-level tax increases were "kind of huge," says Ray Scheppach, executive director of the National Governors Association. Given the risk of voter backlash, states have "maxed out on taxes," he added. The pain was particularly severe in higher-income states in the northeast and along the coasts, according to the Tax Foundation. Of the $24 billion increase tallied by the National Governors Association, California accounted for almost $10 billion and New York more than $6 billion.

The overall rise amounts to 0.25% of consumer spending in the U.S. and 2% of spending on durable goods. Those figures might appear small, say economists, but they're significant enough for people to feel the pinch, especially at a time when spending is weakened by high joblessness and reduced savings. They also don't account for tax increases on the local level. Even after the real-estate bubble burst, many counties, cities and school districts continued to raise property taxes.

Between late 2008 and the end of 2009, while income-tax and sales-tax collections were plummeting, combined state and local property-tax collections grew, albeit slowly, according to a study by the Rockefeller Institute of Government at the State University of New York in Albany. That general trend was likely to continue, the Tax Foundation suggested in a separate report this year.

In New Jersey, where residents have some of the highest combined state and local tax burdens in the country, 11 towns saw an average property-tax increase of more than 10% in 2009. In Jersey City, residents were hit with a rise of more than 22% for fiscal 2010. A Pew Research/National Journal poll in June found that 58% of Americans oppose tax increases to balance state budgets. Cuts to transportation spending were less unpopular than tax hikes as a solution; cuts to education and public safety were more unpopular.

As the anti-tax rhetoric heats up, Democrats find themselves on the defensive. In southern New Jersey, former NFL football player Jon Runyan, the Republican candidate for congress, has been pounding freshman Democrat John Adler for his tax record during his long service in the state Senate. Mr. Adler in return has attacked Mr. Runyan for claiming a local tax break for keeping donkeys at his estate.

In southern Indiana, the national GOP congressional campaign ran a TV ad attacking Democratic nominee Trent Van Haaften over his tax record in the state House. "His TV ads will be beautiful… Nice pictures… Sweet music. But his record? Not so beautiful," the ad intones. Mr. Van Haaften is now talking tough on taxes. "We need to reauthorize the tax cuts of 2001 and 2003. That money belongs to taxpayers," he told a local newspaper recently.

Most congressional Democrats are behind the White House's plan to let some Bush-era cuts expire. But more than 30 House Democrats have come out publicly in favor of extending all the Bush cuts at least temporarily. Several are locked in tough re-election campaigns in high-income, high-tax areas. In the Senate, at least five members of the Democratic caucus have signaled concern about raising taxes—enough to potentially stymie any legislation.

Pennsylvania has seen its state and local tax burden climb steadily for a decade, bringing it to the 11th highest in the country in 2008, up from 20th in 2001, according to the Tax Foundation. In suburban Delaware County, which forms the core of the 7th congressional district, property taxes rose 12.6% in one school district for 2010-2011, and by between 5% and 8% in four others, well in excess of a state target. One small district in nearby Bucks County adopted a 15% increase.

State Rep. Bryan Lentz, the Democratic candidate in the 7th district, narrowly defeated a longtime Republican incumbent in the 2006 state election. He has supported a handful of proposed tax increases in recent years, including a tobacco tax hike, a phase-out of a sales-tax rebate for retailers, and a levy on companies tapping shale for natural gas. Not all have become law, Mr. Lentz notes. But the votes opened the door to attacks from his Republican rival, former U.S. Attorney Pat Meehan.

"I take Bryan to task" for his tax and budget record, Mr. Meehan said during the candidates' first debate in late August. That includes "voting for the $1 billion in…new expenditures, and $500 million in new taxes, another job-killing thing." At a town hall meeting at a Conshohocken fire station in late July, Mr. Lentz joined the growing number of Democrats who are distancing themselves from their leaders when he told the crowd he would support extending several of the Bush-era tax cuts for the wealthiest Americans.

"People are concerned about tax increases in a down economy," Mr. Lentz explained later, standing in the fire-station parking lot. Saying to voters that "we're going to increase your taxes at a time when you have less, you're nervous—that's universally rejected." Mr. Lentz's retreat occurred days after House Speaker Nancy Pelosi held a fund-raiser for him in Philadelphia along with Vice President Joe Biden. Mr. Lentz, a former Army Ranger and Iraq war veteran, rejects the idea that he's giving ground in response to his opponent's attacks. His Republican opponent has taken a no-new-taxes pledge, which Mr. Lentz calls irresponsible and a "campaign gimmick."

"Unlike Pat [Meehan] I've had to vote on a budget," he said during the candidates' second debate on a Philadelphia radio station in late August. "In Washington D.C. they have a credit card.… In Harrisburg we have to balance the budget."

The Fed Is Pushing On A String
by John Mauldin - Frontlinethoughts

The Fed issued the usual statement at the end of their meeting this week, and Fed watchers poured over the words, looking carefully for any sign of change in Fed policy. The consensus seems to be that the most important change was the statement concerning inflation, the first such change in over a year.

"Measures of inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability."

The next (and only other real) change was:

"The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate." (my emphasis)

Translation: inflation may be getting too low, but don't worry, we are on the job.

One of my laugh lines in my speeches (I don't have that many) is: "When you are appointed to the Federal Reserve they take you into a back room and do a DNA change on you. After that, you are viscerally and genetically opposed to deflation."

Bernanke made his famous helicopter speech about not allowing deflation to happen back in 2002. He happily assured us that the Fed has many tools to fight deflation and that it won't happen here. Of course, he also told us the subprime problem would be contained, but I am sure that we have to give him a bit of slack - we all miss a few, including your humble analyst. (Well, I didn't miss the subprime thingie. Nailed that one.)

Anyway, the Fed seems to be setting us up for another round of quantitative easing. That is Fed speak for buying a few trillion or so dollars of government debt and injecting said cash into the economy.

Before we get into the wisdom of such a move, let's look at what might prompt them to do so. This is where we get into speculation.

Recessions are by definition deflationary, but if we go into recession when inflation is already as low as it is, the Fed will be behind the curve. But telling us they are going to start easing because they are worried about a recession is not a good recipe for a positive market reaction.

So? Why not just say that they are worried about the lack of inflation, "at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability." That way they are not fighting a weak economy but rather something that everyone understands, i.e., deflation.

I agree with David Greenlaw from Morgan Stanley. He writes:

"Growth data still take precedence. The change in the inflation language, while important, does not, in our view, signal an elevated emphasis on the incoming inflation data itself as a possible trigger for asset purchases. To be sure, the inflation data do matter, but the growth indicators matter more because, from the Fed's perspective, the pace of growth in economic activity is a leading indicator of inflation. Here is a key excerpt from Bernanke's Jackson Hole speech that helps explain the perceived link between growth and inflation:

" '...the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.' " (emphasis added)

The key driver for whether the Fed enters into another round of quantitative easing, likely to be in the trillions, is the growth in the US economy. If we are above 1.5-2%, I think they will hesitate, for reasons I go into below. If we drop below 1% and it looks like we are getting weaker, then they are likely to act. A slide into recession would bring about deflation. As noted, they are viscerally opposed to deflation.
An Invitation to an Inflation Party

The question in my mind is whether a few trillion dollars spent purchasing government debt would do the trick. What if they sent out invitations to an inflation party and nobody came? Let's look at some data points.

The Fed purchased $1.25 trillion in mortgage assets last year. The theory was that injecting money into the economy would cause banks to take that money and lend it, jump-starting the economy and bringing us back into a normal recovery. Let's see how the lending part went. Here are a few graphs from the St. Louis Fed FRED database.

The first is "Bank Credit of All Commercial Banks." Please note that the straight upward line in the middle of 2010 is an accounting change. Without that the trend would still be down.


Then we have "Total Consumer Credit Outstanding." That had been growing steadily for 65 years until this last recession.


Next we have "Commercial and Industrial Loans at All Commercial Banks."


We could look at total residential mortgages (down); credit card debt (down); and commercial mortgages (down). The list goes on.

Sidebar from Greg Weldon:

"Also, the value of Commercial Property Loans classified as Special Servicing (restructured and-or- extended) rose to a NEW HIGH, pegged at 11.74% of all CMBS, as evidenced in the chart below."


No wonder commercial mortgages are down.

So, what happened to the trillion-plus dollars? It doesn't look like it went into bank lending. As it turns out, it went back onto the balance sheet of the Federal Reserve. Banks put it back into the Fed. There are several ways you can measure this with the FRED database, but one way is to look at "Reserve Balances with Federal Reserve Banks, Not Adjusted for Changes in Reserve Requirements."


If banks are not lending now, with what seems like lots of reserves, then what is to make us think that another $2 trillion in QE will make them feel like they have too much money in their vaults?

If it is because they don't have enough capital, then adding liquidity to the system will not help that. If it is because they don't feel they have creditworthy customers, do we really want banks to lower their standards? Isn't that what got us into trouble last time? If it is because businesses don't want to borrow all that much because of the uncertain times, will easy money make that any better? As someone said, "I don't need more credit, I just need more customers."

How much of an impact would $2 trillion in QE give us? Not much, according to former Fed governor Larry Meyer, who, according to Morgan Stanley, "...maintains a large-scale macro-econometric model of the US economy that is widely used in the private sector and in public policy-making circles. These types of models are good for running 'what if?' simulations. Meyer estimates that a $2 trillion asset purchase program would: 1) lower Treasury yields by 50bp; 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012; and 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012. However, Meyer admits that these may be 'high-end estimates'.

"Some probability of a resumption of asset purchases is already priced in, and thus a full 50bp response in Treasuries is unlikely. Moreover, a model such as Meyer's is based on normal historical relationships and therefore assumes that the typical transmission mechanisms are working. For example, a drop in Treasury yields would lower borrowing costs for consumers and businesses, helping to stimulate consumption, business investment and housing. But there is good reason to believe that the transmission mechanism is at least partially broken at present, and thus the pass-through benefit to the economy associated with a small decline in Treasury yields (relative to current levels) would likely be infinitesimal." (Morgan Stanley)

That is not much bang for the buck, so to speak, but it would be pointing a gun with a very big bang at the valuation of the dollar. If QE were attempted on that scale, it would not be good for the dollar. My call for the pound and the euro to go to parity with the dollar would be out the window for some time, and maybe for good.

Now, if the strategy is to lower the dollar, then QE might make some sense; but of course no one would admit to that, not when we are accusing other countries of manipulating their currencies (as in China). No, we would just be fighting deflation. The fact that the dollar dropped would just be a coincidence, a necessary but sad thing in the important fight against deflation. (Please note tongue firmly in cheek. Not you, of course, but some other readers sometimes miss my sarcasm.)

Of course, not all agree that a lower dollar would necessarily be a bad thing. Ambrose Evans-Pritchard, writing in the London Telegraph, concludes a column in where he notes that there is a lot of opposition to QE2 from some fairly significant economic luminaries, and that:

"Dr Bernanke said in November 2002 that Japan had the economic instruments to pull itself out of malaise but failed to do so. 'Political deadlock' and a cacophony of views over the right policy had prevented action. He insisted that a central bank had 'most definitely' not run out of ammo once rates were zero, and retained 'considerable power to expand economic activity'.

"Yet eight years later, the US is in such 'deadlock'. Worse, Fed officials now say 'the ball is in the fiscal court', arguing that budget policy should do more to 'complement' the Fed's existing stimulus. Oh no!

"This is the worst possible prescription. What is needed is fiscal austerity (slowly) before debt spirals out of control, offset by easy money or real QE for as long as it takes. This formula rescued Britain from disaster in 1931-1933 and 1992-1994.

"Damn the rest of the world if they object. They have been free-loading off US demand for too long. A weaker dollar will force the mercantilists to face some hard truths. So keep those helicopters well-oiled and on standby."

Hmmmm. If everyone else wants to devalue their currency, should we play along? Can you say buy some more gold?

But back to the inflation party invitation. If the economy is recovering, QE is not needed. Note that the US economy in the current quarter may be doing better than last. And if you looked at the bank lending charts I presented above, an optimist could note that it looks like we might be seeing a bottom forming and even some increase in lending. Perhaps we have turned the corner. Again, the banks have plenty of reserves, so another $2 trillion is not needed.

But what if they went ahead and threw $1-2 trillion against the wall? If it showed up back at the Federal Reserve, it would only serve to show that the Fed does not have the tools it needs, or would have to be really willing to monetize debt. It would be Keynes' "liquidity trap" or what Fisher called debt deflation. Neither are good.

That's called pushing on a string. If the markets sensed that, it would not be pretty.

The Fed has been buying government debt for several months, taking the money from the mortgages that are being amortized and buying the debt. Let's maybe see how that works out before we bring out the big guns. Just a thought.

I agree with Allan Meltzer, a historian of the US central bank:

" 'We don't have a monetary problem, we have 1 trillion or more in excess reserves, so it's literally stupid to say we're going to add another trillion to that,' Meltzer, a professor at Carnegie Mellon University in Pittsburgh, said today in an interview on Bloomberg Television's 'InBusiness With Margaret Brennan.'

" 'One of the major mistakes that the Fed makes all the time is too much concentration on the short-term,' said Meltzer, author of a history of the Fed. 'Aiming at that is just a fool's game.' " (Business Week)

That being said, we live in a world where we need to act in terms of what will be rather than what should be. And if the economy continues to weaken, I think it is likely the Fed will act preemptively and start QE2. So the next few months of economic data are very important.

And even more important is whether Congress will extend the Bush tax cuts at least until the economy is growing respectably, when they come back for the lame duck session in November. Not extending them would be a policy mistake bigger than QE2, and might force even more precipitous action. We do live in interesting times.

Shut Down the Fed (Part II)
by Ambrose Evans-Pritchard - Telegraph

I apologise to readers around the world for having defended the emergency stimulus policies of the US Federal Reserve, and for arguing like an imbecile naif that the Fed would not succumb to drug addiction, political abuse, and mad intoxicated debauchery, once it began taking its first shots of quantitative easing.

My pathetic assumption was that Ben Bernanke would deploy further QE only to stave off DEFLATION, not to create INFLATION. If the Federal Open Market Committee cannot see the difference, God help America.

We now learn from last week’s minutes that the Fed is willing “to provide additional accommodation if needed to … return inflation, over time, to levels consistent with its mandate.” NO, NO, NO, this cannot possibly be true.

Ben Bernanke has not only refused to abandon his idee fixe of an “inflation target”,  a key cause of the global central banking catastrophe of the last twenty years (because it can and did allow asset booms to run amok, and let credit levels reach dangerous extremes). Worse still, he seems determined to print trillions of emergency stimulus without commensurate emergency justification to test his Princeton theories, which by the way are as old as the hills.  Keynes ridiculed the “tyranny of the general price level” in the early 1930s, and quite rightly so. Bernanke is reviving a doctrine that was already shown to be bunk eighty years ago.

So all those hillsmen in Idaho, with their Colt 45s and boxes of krugerrands, who sent furious emails to the Telegraph accusing me of defending a hyperinflating establishment cabal were right all along. The Fed is indeed out of control. The sophisticates at banking conferences in London, Frankfurt, and New York who aplogized for this primitive monetary creationsim – as I did – are the ones who lost the plot.

My apologies. Mercy, for I have sinned against sound money, and therefore against sound politics. I stick to my view that Friedmanite QE ‘a l’outrance‘ is legitimate to prevent a collapse of the M3 broad money supply, and to prevent outright deflation in economies with total debt levels near or above 300pc of GDP. Not in any circumstances, but where necessary, and where conducted properly by purchasing bonds outside the banking system (not the same as Bernanke “creditism”).

The dangers of tipping into a debt compound trap – as described by Irving Fisher in Debt-Deflation Theory of Great Depresssions in 1933 – outweigh the risk of an expanded money stock catching fire and setting off an inflation surge later. Debt deflation is a toxic process that can and does destroy societies as well as economies. You do not trifle with it.

But deliberately creating inflation “consistent” with the Fed’s mandate – implicitly to erode debt – is another matter. Nor can this be justified at this particular juncture. M3 has been leveling out. M2 has begun to rise briskly. The velocity of money has picked up. The M1 monetary mulitplier has jumped.

We have a very odd world. The IMF has doubled its global growth forecast to 4.5pc this year, and authorities everywhere have ruled out a serious risk of a double dip recession. Yet at the same time the Bank of Japan has embarked on unsterilised currency intervention, which amounts to stimulus, and both the Fed and the Bank of England are signalling fresh QE.

You can’t have it both ways. If the US is not in deep trouble, the Fed should not be thinking of extra QE. It should step back and let the economy heal itself, if necessary enduring several years of poor growth to purge excess leverage.

Yes, U6 unemployment is 16.7pc. But as dissenters at the Minneapolis Fed remind us, you cannot solve a structural unemployment crisis with loose money. Fed is trying to conjure away the hangover from the last binge (which Greenspan/Bernanke caused, let us not forget), as if to vindicate its prior claim that you can always clean up painlessly after asset bubbles.

Are the Chinese right? Are the Americans and the British now so decadent that they will refuse to take their punishment, opting to default on their debts by stealth? Sooner or later we may learn what the Fed’s hawkish bloc of Fisher, Lacker, Plosser, Hoenig, Warsh, and Kocherlakota really think about this latest lurch into monetary la la land, with all that it implies for moral hazard and debt contracts. If I have written harsh words about these heroic resisters, I apologise for that too.

Fed Mulls New Bond Approach
by Jon Hilsenrath

Federal Reserve officials are considering new tactics for the purchase of long-term U.S. Treasury securities to bolster a disappointingly slow recovery. Rather than announce massive bond purchases with a finite end, as they did in 2009 to shock the U.S. financial system back to life, Fed officials are weighing a more open-ended, smaller-scale program that they could adjust as the recovery unfolds.

The Fed hasn't yet committed to stepping up its bond purchases, and members haven't settled on an approach. After its meeting last week, the Fed's policy committee said it was "prepared" to take new steps if needed. A decision on whether to buy more bonds depends on incoming data about economic growth and inflation; if the economy picks up steam, officials might decide no action is needed.

The Fed's internal debate about a bond-buying strategy is emblematic of the challenging position in which it finds itself. In normal times, it simply raises or lowers short-term interest rates to guide the economy. But having pushed short-term rates to near zero, it now has to devise new, untested approaches at almost every turn. A misstep could lead to unintended consequences, one factor that makes officials wary and investors jittery about its every move.

In theory, buying long-term bonds pushes other interest rates down because it reduces the supply of debt available to investors, pushing up the price of this debt and the yield down. In March 2009, the Fed said it would buy $1.7 trillion worth of Treasury and mortgage-backed securities over a six to nine month period—known inside the Fed as the "shock and awe" approach. Most Fed officials believe that helped to drive down long-term interest rates and spurred the economy.

Under the alternative approach gaining favor inside the Fed, it would announce purchases of a much smaller amount for some brief period and leave open the question of whether it would do more, a decision that would turn on how the economy is doing. This would give officials more flexibility in the face of an uncertain recovery.

Most economists at the Fed and outside, though not all, believe that the Fed's decision to embark on what's known as "quantitative easing"—buying bonds—after cutting its target for short-term interest rates to near zero helped prevent an even deeper recession. A move to resume the purchases would be a big step for the Fed, which just a few months ago was talking about how to reduce its portfolio.

In deciding how to resume its large-scale purchases, if it opts to do so, the Fed is considering both the potential benefits of pushing down already-low long-term interest rates and the potential risks, particularly to its credibility in financial markets about its ability and willingness to reverse course if the economy rebounds or inflation accelerates. Fed officials have done little to dissuade investors that they might do more.

Fed Chairman Ben Bernanke last week reiterated his dissatisfaction with the recovery, saying the economy has failed to grow "with sufficient vigor to significantly reduce the high level of unemployment." Markets anticipate the Fed will pull the trigger, barring some surprise turn in the economy. Economists at Goldman Sachs Group Inc. estimate the Fed will end up purchasing at lest another $1 trillion in securities, and estimate that would push long-term interest rates down by a further 0.25 percentage point.

A leading public proponent of a baby-step approach is James Bullard, a 20-year Fed veteran who has been president of the St. Louis Federal Reserve Bank since 2008. He says he has made progress convincing his other colleagues to seriously consider that path. "The shock and awe approach is rarely the optimal way to conduct monetary policy," he says. "I really do not think it is the right way to go except in really exceptional circumstances."

In the heat of the crisis it made sense to jar frozen markets back to life with a big attention-grabbing program, he says. Announcing another big program with a finite end date now, he says, would lock the Fed into a policy that might not prove appropriate several months from now. Moreover, a large commitment could destabilize markets by unhinging the dollar or creating fears of a big inflation uptick, he says.

Under a small-scale approach, Mr. Bullard says, the Fed might announce some still-undecided target for bond buying—say $100 billion or less per month. It would then make a judgment at each meeting whether continued action was needed, he says, based on whether "we're making progress toward our mandate of maximum sustainable employment and inflation at our implicit inflation target."

There are many open questions. One is size. Mr. Bullard says doing more than $1 trillion of purchases per year would give him "pause" because that's how much net debt the Treasury will issue this year, meaning the Fed would be financing it all. There is also a question of whether the Fed might tie further action to movements in the unemployment rate, inflation or other metrics.

Mr. Bullard currently is among 12 regional Fed bank presidents with a vote on monetary policy, along with the four current Fed governors in Washington. He has been arguing for this kind of approach to Fed policy for several months, but only began to get traction with other officials as the economy slowed down this summer. The Fed is not of one mind on the issue, though. Some officials are reluctant to resume bond buying to, as they put it, "fine tune" the economy. Others are more inclined to be bold to resuscitate the recovery. A small-scale approach could be a path to compromise among officials.

"Given the disagreement about the need for additional easing within the FOMC, retaining some flexibility might be critical to the adoption" of more quantitative easing, Goldman Sachs analysts said recently. The Goldman economists estimate that an open-ended, small-scale approach would have less impact on bond markets than a large one-time approach, because investors wouldn't be certain about whether such a program would continue. "The more you commit to large amount of purchases up front, the bigger effect you're going to get," says Jan Hatzius, Goldman's chief economist.

The Fed concluded its $1.7 trillion purchases of mortgage and Treasury bonds in March. Researchers at the Federal Reserve Bank of New York estimate that the program reduced long-term interest rates by between 0.3 percentage point and 1 full percentage point. The Fed took a step toward new purchases in August. It said it would begin replacing maturing mortgage bonds by purchasing Treasury debt to keep the overall level of its securities holdings constant.

Deflation And Discouragement
by TPC

Most economists ignore the behavioral side of finance.  They tend to stick to their models, equations and textbooks.  This is, in large part, what makes economics such a frustrating endeavor for so many people.  They tend to ignore the simple fact that there is an unquantifiable variable in the equation – human emotion.  And no matter how much we evolve and advance technologically this variable will always be the most important piece of the puzzle.

Over the last few years I have argued that much of what the government planned to do would have destructive psychological ramifications.  Unfortunately, this appears to have come true as no one truly trusts the stock market these days.  Small business sentiment shows a total lack of faith in the government.  Consumer confidence remains abysmal. This is all very disconcerting because a deflationary environment has a way of snowballing and becoming self destructive.   It can eat at a society from within as they become discouraged.  The following story nicely summarizes the damaging impact of deflation:
"Once upon a time it was announced that the devil was going out of business and would sell all his equipment to those who were willing to pay the price.
On the big day of the sale, all his tools were attractively displayed. There were Envy, Jealousy, Hatred, Malice, Deceit, Sensuality, Pride, Idolatry, and other implements of evil display. Each of the tools was marked with its own price tag.
Over in the corner by itself was a harmless looking, wedge-shaped tool very much worn, but still it bore a higher price than any of the others. Someone asked the devil what it was, and he answered, "That is Discouragement." The next question came quickly, "And why is it priced so high even though it is plain to see that it is worn more than these others?"
Because replied the devil, "It is more useful to me than all these others. I can pry open and get into a man’s heart with that when I cannot get near him with any other tool. Once I get inside, I can use him in whatever way suits me best. It is worn well because I use it on everybody I can, and few people even know it belongs to me."

This tool was priced so high that no one could buy it, and to this day it has never been sold. It still belongs to the devil, and he still uses it on mankind."

I believe this is exactly what happened in Japan in the 90?s.  Deflation became accepted.  And as it became accepted discouragement came with it.  And discouragement has a nasty way of eating at people’s everyday activities.  When you are discouraged by the environment you exist in you are more likely to quit, not to participate or to simply sit on your hands while you wait for things to improve.  Prices fall, wages decline, profits suffer, etc.

The government is trying to talk us out of becoming discouraged.  They have rescued the financial system with record bailouts, trillions in stimulus and hope-filled messages.  This continues to this day.  We are told that the Federal Reserve will bolster markets with quantitative easing and supportive monetary policy.  We are told that the government will stimulate Main Street and small business.  We are told that they will give us tax credits for buying new cars or new homes.  We are told that saving the banks will save us all.  But when one looks under the hood at all of these policies you realize that none of them have been beneficial to Main Street.  Almost without exception they have been short-term attempts to bolster a banking system that has failed us.

Quantitative easing is just the latest gimmick to bolster bank balance sheets and generate hope of a real recovery. Real recovery will come when Main Street is cured of its debt disease.  Until then, discouragement will continue to eat at the core of this system as the government continues down its misguided path.  I used to think that Americans were too hopeful and prideful to be discouraged for any extended period, but this government appears to be doing a pretty good job of scaring us with their rhetoric while also implementing policy that proves them entirely ignorant in regards to all things economics. Until something actually changes in Congress it’s likely that the threat of deflation and discouragement will remain. And with it will be depressed economic growth.

Here's Where All That Government Spending Is REALLY Going
by Henry Blodget - Business insider

The Congressional Budget Office is basically projecting $1-trillion dollar annual Federal budget deficits for as far as the eye can see.

This will require the country to pile another $1 trillion of debt on top of our existing $13.5 trillion debt load each year, which will quickly drive our national debt-to-GDP ratio over 100% (Greece-like).

So, naturally, people are concerned about all that government spending.

So where's it going, really?

Well, when you dig into the CBO's 10-year estimates for the growth in Federal spending over the period, you find that Federal government spending is expected to increase by about $2 Trillion a year over the next 10 years.

Where's that money going?

It's basically going to three things:

1. Entitlement programs (Social Security, Medicare, Medicaid) -- +~$1.2 Trillion, or 60% of the increase

2. Interest on our debt -- +~$750 billion, or 37.5% of the increase

3. Everything else -- $50 billion, or 2.5% of the increase

Here's a chart that shows this, from Paul Kasriel at Northern Trust:

Change In Federal Spending, 2011-2020

Image: Northern Trust

What everyone's fighting about right now, by the way, is that little green bar--"everything else"--the 2.5%.

Maybe it's time we turned our attention to the other 97.5%?

Paul Kasriel has more:

As the chart shows, the largest projected increase in spending by an order of magnitude over these years is for mandatory or entitlement programs - Social Security, Medicare and Medicaid. Demographics is the primary factor driving up these entitlement expenditures. Millions of baby boomers will become eligible for Social Security and Medicare benefits during the period covered in these projections.

The second largest projected increase in federal expenditures is interest on the debt. On a percentage basis, this is the fastest growing category of federal outlays. Why is interest on the public debt growing so rapidly over this period? Partly because of the interest on all of the public debt piled up as a result of the federal budget deficits being incurred in each of the past fiscal years starting in 2002.

That relatively small (green) bar in the chart represents the projected increase in all other federal outlays besides entitlement programs and interest on the public debt. The upshot of all this is that if one is serious about slowing the rate of increase in federal government outlays in the "out years," reduce entitlements for baby boomers. Good luck with all that.

Walking away with less
by Dina ElBoghdady and Dan Keating - Washington Post

A new wave of distressed home sales is rippling, more quietly this time, through American cities and suburbs. Its unsettling effects are playing out here in Manassas, along Brewer Creek Place, a modest, horseshoe-shaped street lined with 98 brick townhouses. Several years after the U.S. foreclosure crisis erupted, the U-Hauls are back. The last time, banks seized nearly every fourth house on the street through foreclosure. This time, homeowners are going another route: a short sale.

"I love this house, but I just have to leave," said Leanna Harris, 27, the owner of a corner unit that used to be the builder's model, with a stone path in the yard and a gourmet kitchen. "I'm at peace with it now." The original owner bought the home for $400,714 in 2006; Harris and her husband, both bartenders, paid what seemed to be a bargain price, $289,000, in 2008. But they have fallen behind on their mortgage payments, in part because her husband was out of work. Now they have a $246,000 offer for the home, and the balance on their mortgage is more than that. They want to accept the offer. All they need is their bank's okay.

That kind of deal is called a short sale, and it's sweeping the country. In these deals, a lender allows a troubled borrower to sell a home for less than what's owed on the mortgage. Completed short sales have more than tripled since 2008, and 400,000 of these deals are projected to close this year, according to mortgage research firm CoreLogic. The giant mortgage financier Fannie Mae approved short sales on 36,534 home loans it owned in the first half of the year, nearly triple the number in 2007 and 2008 combined. Freddie Mac, its sister company, approved 22,117 in the first half of 2010, up from a mere 94 in the first half of 2007.

Distressed homeowners are being drawn to short sales in large part because they can help protect a borrower's credit rating and thus the chance of buying another home later on. "I worked hard for a long time to keep my credit score close to perfect, and I know a foreclosure would be much worse for my credit than a short sale," said Harris, who listed her Brewer Creek Place home as a short sale about a month ago. "If there's a chance we can avoid foreclosure, we'd rather do that."

In a short sale, homeowners must get the go-ahead from the mortgage lender. Sometimes that happens before the property is put on the market, and other times before the deal closes. In some areas of the country, including the Washington region, lenders can later pursue borrowers for the difference between the proceeds collected from the short sale and the amount owed on the mortgage, also called a deficiency. But lenders say they only do so if they conclude the borrowers skipped out on a loan that they could afford.

For lenders, short sales are less expensive than foreclosures to handle and help ensure that homes transfer in good shape. And for the wider real estate market, these sales could help shore up the floor under housing values because homeowners - unlike with foreclosures - have a vested interest in getting the best price. That's because the higher the offer, the more likely the lender will approve the sale. But short sales are prone to maddening delays and often fall through because they require the approval of many, often-competing parties - including the primary mortgage lender and in some cases the holders of second and third liens.

Across the Washington region, short-sale listings now far outpace the number of foreclosures available for sale, according to RealEstate Business Intelligence, a subsidiary of the local multiple listing service. About 14 percent of area homes for sale are short sales, more than double the figure for foreclosures, with some of the greatest volume in Prince George's and Prince William Counties, where the drop in housing prices has been especially pronounced.

Brewer Creek Place, which wraps around the back end of the Independence subdivision south of the Prince William Parkway, was first developed five years ago on the eve of the housing market meltdown. Most of the residents bought their townhouses at a time when mortgage lending standards were especially lax, leaving some borrowers saddled with staggering debts when the home-loan market collapsed. Yet along the street, there are few signs of the turmoil. Kids zip around on scooters. Neighbors primp their flower beds.

But from her driveway, Brenda Holliday has watched the crisis spread. Taking a break from hosing down her convertible PT Cruiser on a recent Saturday, she pointed to the three homes to her right. Each had sold as a foreclosure since 2008. Then she pointed to the door to her immediate left with a lock box hanging on it. "That's a short sale," she said. She nodded to the corner unit further down the block. "I think that's a short sale, too."

To Holliday, 60, her townhouse seemed ideal when moved in four years ago shortly after she was widowed. She's been renting the place from the owner with half of each monthly payment credited toward her eventual purchase of the home, which she initially agreed to buy for $365,000. But as she's grown older, the stairs have gotten harder, she said, and now she feels a bit trapped. If she leaves, she loses the money she put toward the purchase. If she stays, she'll have to pay about $150,000 more than the townhouse is worth. Its value has been eroded by the steady stream of foreclosures and short sales.

Holliday squeezed the hose full throttle. "A moving van pulls up and another family is gone - that's all I know," she said. "It's plain sad."

Leanna Harris may have been the first on the street to buy a home as a short sale. When she did, in early 2008, such deals were so rare that Prince William County hadn't even started to track them yet. "I wanted this house really bad," said Harris, who went to settlement on the home the day after their baby girl was born. "It is my dream house." But before long, she and her husband were looking at a short sale from the other side. The Harrises fell behind on their payments and never regained financial footing, she said.

The couple received temporary relief for six months from Bank of America. But Harris said the bank ultimately rejected them for a permanent loan modification and threatened foreclosure unless they immediately made up the $10,000 in payments that had been deferred, including interest and fees, or sold the house. Harris said she felt tricked. But she listed her home as a short sale because it seemed to offer a relatively painless way out. She said she doesn't expect the bank's approval to come quickly.

Lenders acknowledge that they are overwhelmed with the volume of short sales coming their way. "It has taken considerable effort to build up the capacity to do these [short sale and modification] processes and also to connect them together," said David Sunlin, a senior vice president at Bank America. "We're adding staff and vendors and technology."The giant mortgage financier Fannie Mae approved short sales on 36,534 home loans it owned in the first half of this year, nearly triple the number in 2007 and 2008 combined. Freddie Mac, its sister company, approved 22,117 in the first half of 2010, up from a mere 94 in the first half of 2007.

The Obama administration, meanwhile, has been seeking to encourage even more short sales as a way of reducing the nation's inventory of vacant and abandoned properties. In April, the administration launched a program that financially rewards lenders and borrowers for successfully negotiating a short sale if the borrower's loan could not be modified through the federal government's year-and-a-half-old foreclosure prevention effort. Lenders receive $1,500 and borrowers another $3,000 for moving expenses. Under the initiative, all eligible borrowers must be notified of the option to sell their homes short before their loans are referred to foreclosure.

The Treasury-run program also sweetens the deal for borrowers by relieving them of any obligation to repay a deficiency. Clearing the way for a short sale has often proved cumbersome because there can be so many parties to a potential deal. Aside from lenders, transactions may also have to be green lighted by investors who own the mortgages, local tax authorities, appraisal firms, escrow companies, homeowners associations, mortgage insurance companies and subordinate lien holders.

That's why the administration cannot simply order a lender to approve a short sale, said Laurie Maggiano, policy director at the Treasury Department's homeownership preservation office. "We have to give servicers discretion to make intelligent business decisions as to which properties are likely to be successful short sales, rather than say everybody has to get one," she said. It can also be difficult to persuade lenders to participate, because of the risk. According to Frank McKenna, a vice president at CoreLogic, the industry is on track to incur about $310 million of unnecessary losses on these transactions every year.

Monica Valladares, 29, has been trying to offload her home on Brewer Creek Place for more than a year. She bought it new for $329,000 in 2006. Keeping up with her mortgage payment was easy when her three roommates - her grandmother and two cousins - were chipping in. But the arrangement fell apart, the family scattered and Valladares, a single mom, said she could not afford the home on her salary as a researcher for a telecommunications company.

In early 2009, Valladares listed the townhouse as a short sale for the first time. The home, overlooking a wooded lot and playground, quickly attracted multiple offers. The highest was $220,000, she recalled. She moved out, thinking the turnaround would be quick. But her agent could not get the bank to review even the most lucrative contract, she said.

When the potential buyers dropped out about six months later, Valladares applied to Bank of America for a loan modification that would reduce her payments. A few months later, Valladeres was told she did not qualify, she said. Desperate, Valladares tried the short-sale route again. "I don't know what else to do, what else to try," Valladares said during a recent visit back to the vacant town home. "This house is damaging my credit big time." Within days, she received a $220,000 offer.

When she called her primary lender to get approval for the deal, however, the bank said she wasn't eligible for a short sale because she had been enrolled in a loan modification program after all, Valladares recalled. Straightening out the confusion took weeks. The lender finally agreed to the sale. But there were more obstacles. For one, the homeowners association said Valladares must pay $4,000 in dues and late fees before it will clear the sale, she said, adding she doesn't have the cash.

Yet another problem is that Valladares had taken out a second mortgage to help her finance the original purchase of her townhouse. The lender on that second loan has yet to approve the short sale, said Roger Derflinger, her current real estate agent. "The offers come quick," Valladares said. "It's the bank that's slow."

Third Of Americans Can't Get Mortgages As Interest Rates Hit Record Lows
by William Alden - Huffington Post

Even as a glut of unsold inventory keeps the housing market from recovering, nearly a third of Americans can't qualify for home mortgages, according to new data from online real estate search company Zillow.

Would-be homeowners with credit scores below 620 points were largely unable to take out 30-year mortgages in the first half of September, even if they offered down payments as high as 25 percent, Zillow found after analyzing more than 25,000 loan quotes and purchase requests on its website. A full 29.3 percent of Americans have a credit score that low, Zillow says, citing data from myFICO.

Mortgage interest rates, meanwhile, are at a low not seen in at least 40 years. According to data compiled by the St. Louis Fed, the average interest rate on a 30-year mortgage was 4.37 percent as of September 16. The St. Louis Fed has data going back to 1971 and, in that period, before 2009, the interest rate never dipped below 5 percent. These days, according to Zillow, the lowest interest rate is 4.3 percent, available only to those with a credit score above 720 points -- about 47 percent of Americans. The higher rates, ranging from 4.44 to 4.9 percent, are available to about 23.8 percent of Americans. The remaining 29.3 percent of the population can't get loans at all.

A variety of factors, including a high volume of foreclosures and weak demand, have depressed the housing market to such an extent that some experts say it won't rebound for three years. But lenders are understandably cautious. While easily accessible mortgages might contribute to a housing recovery, lenders are still shell-shocked from the aftermath of the housing bubble. Banks have been writing off debt in record numbers -- the charge-off rate this year has been higher than any year since at least 1988, according to data from the Saint Louis Fed.

California leaders reach 'framework' of budget deal
by Shane Goldmacher - Los Angeles Times

California's leaders declared a breakthrough in long-stalled budget talks Thursday, as the state approached a dubious milestone: breaking its own record for the longest budget impasse in modern history. After two all-day negotiating sessions in Gov. Arnold Schwarzenegger's private Santa Monica office, the governor's spokesman said they had reached "a framework of an agreement" on eliminating the state's $19.1-billion deficit. Top legislators concurred.

Proclamations of such accord have proved premature in the past, but the negotiators said they could strike a final deal as early as Monday. "We will continue to work throughout the weekend to iron out the details," Assembly Speaker John A. Pérez (D- Los Angeles) said in a statement. But the legislative leaders, who had traveled to Southern California for a rare budget summit outside the state Capitol because Schwarzenegger has a severe cold, left the talks in SUVs and cars without providing details about what was in their framework.

The Democrats had arrived in Santa Monica bearing matzo-ball soup for the governor Wednesday, 84 days into the fiscal year. On Friday, California reaches a new record for a late budget. The previous record was set Sept. 23, 2008. Both Democrats and Republicans have said any new budget is unlikely to raise broad taxes such as sales or income taxes. But the spending plan, once completed, is expected to cut into numerous government services to close the deficit.

Schwarzenegger has vowed not to sign a budget unless it reins in public pensions, and one person with knowledge of the talks said that remained a point of contention. The governor also said there would be no spending plan without some controls on other state spending, and the source said that demand would be met with a future ballot measure. The source spoke on the condition of anonymity because of the delicate nature of the talks.

Eliminating this year's deficit — equal to more than $500 for every man, woman and child in the state — has proved especially intractable. Lawmakers have been at loggerheads for months over what programs to cut or what taxes to raise to close the shortfall. California is one of a handful of states that require a two-thirds vote to pass a budget or approve new or higher taxes.

As Schwarzenegger and lawmakers began meeting Thursday, how much to spend on K-12 education and how to repay schools what they are owed from past years were among the key sticking points. It is unclear how those issues are being resolved. Republicans were amenable — for a price — to the suspension of a corporate tax break allowing businesses to deduct losses in one year from taxes paid in another, according to two people close to the negotiations. The sources, who also spoke on the condition of anonymity, said those discussions were ongoing.

As the summer budget impasse has crept into the fall, a growing number of California's bills are going unpaid — a projected $6 billion through September, according to the state controller. "It's horribly frustrating and devastating," said Jeremy Tobias, executive director of the Community Action Partnership of Kern, which provides child care services in the Central Valley.

His organization is owed more than $900,000 by the state, he said. As a result, services for more than 3,000 children have been reduced or eliminated. Staff has been laid off or had hours reduced, he said. "We're expected to carry the state during this period," Tobias said, "and we're just not in a financial position to be able to do that."

Obama’s Stimulus Plan Made Crisis Worse, Taleb Says
by Frederic Tomesco - Bloomberg

U.S. PresidentBarack Obama and his administration weakened the country’s economy by seeking to foster growth instead of paying down the federal debt, saidNassim Nicholas Taleb, author of "The Black Swan." "Obama did exactly the opposite of what should have been done," Taleb said yesterday in Montreal in a speech as part of Canada’s Salon Speakers series.

"He surrounded himself with people who exacerbated the problem. You have a person who has cancer and instead of removing the cancer, you give him tranquilizers. When you give tranquilizers to a cancer patient, they feel better but the cancer gets worse." Today, Taleb said, "total debt is higher than it was in 2008 and unemployment is worse."

Obama this month proposed a package of $180 billion in business tax breaks and infrastructure outlays to boost spending and job growth. That would come on top of the $814 billion stimulus measure enacted last year. The U.S. government’s total outstanding debt is about $13.5 trillion, according to U.S. Treasury Department figures. Obama, 49, inherited what the National Bureau of Economic Research said this week was the deepest U.S. recession since the Great Depression.

Even after the stimulus measure and other government actions, the U.S. unemployment rate is 9.6 percent. Governments globally need to cut debt and avoid bailing out struggling companies because that’s the only way they can shield their economies from the negative consequences of erroneous budget forecasts, Taleb said.

Errant Forecasts
"Today there is a dependency on people who have never been able to forecast anything," Taleb said. "What kind of system is insulated from forecasting errors? A system where debts are low and companies are allowed to die young when they are fragile. Companies always end up dying one day anyway." Taleb, a native of Lebanon who gave his speech in French to an audience of Quebec business people, said Canada’s fiscal situation makes the country a safer investment than its southern neighbor. 

Canada has the lowest ratio of net debt to gross domestic product among the Group of Seven industrialized countries and will keep that distinction until at least 2014, the country’s finance department said in March. Canada’s ratio, 24 percent in 2007, will rise to about 30 percent by 2014. The U.S. ratio, now above 40 percent, will top 80 percent in four years, the department said, citing IMF data. "I am bullish on Canada," he told the audience. "I prefer Canada to the U.S. or even Europe."

Mortgage Interest
Canada’s economy also benefits from the fact that homeowners, unlike their U.S. neighbors, can’t take mortgage interest as a tax deduction, Taleb said. That removes the incentive to take on too much debt, he said. "The first thing to do if you want to solve the mortgage problem in the U.S. is to stop making these interest payments deductible," he said. "Has someone dared to talk about this in Washington? No, because the U.S. homebuilders’ lobby is hyperactive and doesn’t want people to talk about this." Taleb also criticized banks and securities firms, saying they don’t adequately warn clients of the risks they run when they invest their retirement savings in the stock market.

‘Have Fun’
"People should use financial markets to have fun, but not as a depository of value," Taleb said. "Investors have been deceived. People were told that markets go up regularly, but if you look at the last 10 years that’s not been the case. The risks are always greater than what people are told." Asked by an audience member if returns such as those posted by Berkshire Hathaway Inc. Chief Executive Officer Warren Buffett -- who amassed the world’s third-biggest personal fortune through decades of stock picks and takeovers -- are the product of luck or talent, Taleb said both played a part. 

If given a choice between investing with Buffett and billionaire investor George Soros, Taleb also said he would probably pick the latter. "I am not saying Buffett isn’t as good as Soros," he said. "I am saying that the probability Soros’s returns come from randomness is much smaller because he did almost everything: he bought currencies, he sold currencies, he did arbitrages. He made a lot more decisions. Buffett followed a strategy to buy companies that had a certain earnings profile, and it worked for him. There is a lot more luck involved in this strategy."

Soros gained fame in the 1990s when he reportedly made $1 billion correctly betting against the British pound. Taleb’s 2007 best-seller, "The Black Swan: The Impact of the Highly Improbable," argues that history is littered with rare, high-impact events. Theblack-swan theory stems from the ancient misconception that all swans were white. A former trader, Taleb teaches risk engineering at New York University and advises Universa Investments LP, a Santa Monica, California-based fund that bets on extreme market moves.

This Should Have Raised Red Flags: New Proof Wall Street Knew Its Mortgage Securities Were Subpar
by Shahien Nasiripour - Huffington Post

During a little-noticed hearing this week in Sacramento, Calif., a firm hired by Wall Street to analyze mortgages given to borrowers with poor credit, which were then packaged and sold to investors during the boom years, revealed that as much as 28 percent of those loans failed to meet basic underwriting standards -- and Wall Street knew all along.

Worse, when the firm flagged those loans for potential issues, Wall Street banks ignored its recommendation nearly half the time and likely purchased those loans anyway -- selling them to unwitting investors who were never told that the biggest home loan due diligence firm in the country had found potential defects in these mortgages.

The revelations give a better picture of what many have likely known for years: Wall Street firms knew they were buying lead yet passed it off as gold to investors who had no knowledge of the alchemy behind the scenes. But it also has real-world implications: the data released Thursday could bolster pension funds and other investors in their pursuit to force Wall Street banks to take back the bogus mortgages they peddled. An untold number of lawsuits have been filed in the wake of the subprime mortgage crisis and subsequent housing market collapse. Thus far, Wall Street has been winning that battle.

Clayton Holdings, a Connecticut-based firm that analyzes home mortgages for banks, hedge funds, insurance companies and government agencies, provided its data Thursday to the Financial Crisis Inquiry Commission, a bipartisan panel created by Congress to investigate the roots of the worst financial crisis since the Great Depression. The FCIC held its last public hearing in Sacramento, the home of the panel's chairman, where two current and former top Clayton executives testified under oath about the firm's role in the mortgage securitization chain.

During the height of the boom in 2006 and the period prior to its immediate end during the first six months of 2007, Clayton inspected home loans for Wall Street firms and government-backed mortgage giant Freddie Mac. Clayton looked at loans that the companies wanted to purchase from mortgage originators like New Century Financial, Countrywide Financial, and Fremont Investment & Loan. The company examined 911,039 mortgages, documents show.

Clients included Bank of America and JPMorgan Chase, the nation's two biggest banks by assets which together have about $4.4 trillion; Citigroup, Deutsche Bank, Goldman Sachs, Morgan Stanley, Bear Stearns and Lehman Brothers. Clayton controlled about 50 to 70 percent of the market, Keith Johnson, the firm's former president, told the crisis panel.

Clayton, though, typically looked at roughly 10 percent of the pool of mortgages available for purchase, Vicki Beal, a senior vice president at the firm, said in response to a question by panel chairman Phil Angelides. But during the frenzied last months of the boom, when lenders and securitizers were trying to sell off as much as they could before the market collapsed, that figure reached as low as 5 percent.

Of the 911,000 loans that Clayton scrutinized, 72 percent either met the mortgage seller's standards and other guidelines set by the buyer of the mortgages, typically Wall Street firms, or they had off-setting factors that allowed Clayton to give them a passing grade, like if the borrower who took out the mortgage put a lot of money down or had a very high income.

But 28 percent failed to meet those standards. Of those 255,802 mortgages that Clayton flagged for what were a variety of reasons, Wall Street ended up waiving 100,653 of them, or 39 percent of those loans that did not meet basic standards. And Wall Street firms didn't share this with investors. "This should have raised red flags," said Guy Cecala, publisher of Inside Mortgage Finance, a leading trade publication and data provider.

"To our knowledge, prospectuses do not refer to Clayton and its due diligence work," Beal told the FCIC in prepared remarks. "Moreover, Clayton does not participate in the securities sales process, nor does it have knowledge of our loan exception reports being provided to investors or the rating agencies as part of the securitization process."
Johnson said that Clayton "looked at a lot of prospectuses" -- documents given to potential investors outlining what comprises the deal -- and that the firm wasn't aware of any disclosure to investors of Clayton's "alarming" findings, Johnson said.

The reports Clayton generates are "the property of our clients and provided exclusively to our clients. When Clayton provides its reports to its clients, its work on those loans is generally completed -- Clayton is not involved in the further processes of securitizing the loans and does not review nor opine on the securitization prospectus," Beal said.

During questioning by Angelides, Beal acknowledged that, because the firm was checking roughly 10 percent of the mortgages Clayton's clients were looking to purchase, one could say that Wall Street firms waived in as many as 1 million loans that Clayton had initially rejected. Angelides told the current and former Clayton executives that it appeared that securities issuers -- Wall Street firms -- didn't examine the other 90 to 95 percent of loans that comprised a pool waiting to be securitized and sold to investors. Johnson agreed with him.

Furthermore, Johnson said that he heard that some market participants operated under a "three strikes, you're out rule" -- if bad loans were flagged by Clayton, sellers and issuers would have Clayton take out another 5 to 10 percent sample to check the pool again. Angelides hinted that when done three times, it would be incredibly unlikely that Clayton would again discover those individual questionable loans, and that they'd find their way into securitization deals. Johnson agreed.

"What the standard practice, supposedly, and best practices call for is if you do a sampling and you show problems, you go back and take a bigger slice and keep going until you find out the true extent of the issue and the problem," Cecala said. That didn't happen. "If issuers had been scrutinizing all the collateral in a security and only putting in loans that met actual underwriting and documentation requirements, a lot of these deals wouldn't have gotten done," said Cecala. "But as a practical matter that didn't happen. Most of the loans that were originated got thrown in securities one way or another."

Johnson told the crisis panel that he thought the firm's findings should have been disclosed to investors during this period. He added that he saw one European deal mention it, but nothing else. The firm's findings could have been "material," Johnson said, using a legal adjective that could determine cause or affect a judgment. It's unclear whether the firms ended up buying all of those loans, or whether Wall Street securitized them all and sold them off to investors.

"Clayton generally does not know which or how many loans the client ultimately purchases," Beal said. That likely will be the subject of litigation and investigations going forward.
"This should have a phenomenal effect legally, both in terms of the ability of investors to force put-backs and to sue for fraud," said Joshua Rosner, managing director at independent research consultancy Graham Fisher & Co.

Original buyers of these securities could sue for fraud; distressed investors, who buy assets on the cheap, could force issuers to take back the mortgages and swallow the losses. "I don't think people are really thinking about this," Rosner said. "This is not just errors and omissions -- this appears to be fraud, especially if there is evidence to demonstrate that they went back and used the due diligence reports to justify paying lower prices for the loans, and did not inform the investors of that." Beal testified that Clayton's clients use the firm's reports to "negotiate better prices on pools of loans they are considering for purchase," among other uses.

Nearly $1.7 trillion in securities backed by mortgages not guaranteed by the government were sold to investors during those 18 months, according to Inside Mortgage Finance. Wall Street banks sold much of that. At its peak, the amount of outstanding so-called non-agency mortgage securities reached $2.3 trillion in June 2007, according to data compiled by Bloomberg. Less than $1.4 trillion remain as investors refused to buy new issuance and the mortgages underpinning existing securities were either paid off or written off as losses, Bloomberg data show.

The potential for liability on the part of the issuer "probably does give an investor more grounds for a lawsuit than they would ordinarily have", Cecala said. "Generally, to go after an issuer you really have to prove that they knowlingly did something wrong. This certainly seems to lend credibility to that argument." "This appears to be a massive fraud perpetrated on the investing public on a scale never before seen," Rosner added.

New York Attorney General Andrew Cuomo, who's running for governor, reportedly launched an investigation and granted Clayton immunity in exchange for information on what Wall Street knew and when, according to press reports in January 2008. A spokesman for the state prosecutor didn't return a Friday call seeking comment.

Clayton, for example, analyzed about 10,200 loans for Bank of America. It found problems in 30 percent of them. Of those, the bank waived about a quarter. For Credit Suisse, Clayton found that 37 percent of the 56,300 loans it reviewed failed to conform to standards. It waived a third of those. Clayton discovered that 42 percent of the pool of loans Citigroup wanted to buy didn't meet standards, and that nearly a third of those were waived anyway. Citi is the nation's third largest bank by assets and is still owned by taxpayers.

JPMorgan Chase and Goldman Sachs had rejection rates of 27 and 23 percent, respectively. JPMorgan's waiver rate was 51 percent. Goldman Sachs, often derided for its practices during the boom and bust, had a waiver rate of 29 percent, far below the 39 percent average Clayton experienced.

Among the firms with the worst records are Morgan Stanley, Deutsche Bank and Freddie Mac. About 35 percent of the 66,400 loans Deutsche wanted to buy were marked for having some kind of deficiency; the bank waived half of them. Morgan's 63,000 loans had a rejection rate of 37 percent; 56 percent of them were waived in. Clayton rejected 35 percent of the loans government-owned Freddie Mac wanted to buy. The firm, one half of the mortgage duo now owned by taxpayers and costing the Treasury hundreds of billions of dollars, waived 60 percent of those loans.

Neal, though, testified that Deutsche was one of its tougher clients when it came to checking mortgages. Because of its rigorous guidelines, that's likely why the German lender had such a high rejection rate, she said.

These firms were among the biggest issuers of so-called non-agency mortgage-backed securities in 2006 and the first half of 2007. Goldman issued about $65 billion in these securities, Inside Mortgage Finance data show. JPMorgan issued about $61 billion. Morgan Stanley sold about $49 billion, followed closely by Deutsche which sold $46 billion and Credit Suisse which issued $40 billion. Bank of America and Citigroup were next, selling $37 billion and $35 billion, respectively, data show.

But none of this should be new to savvy market players. Clayton had been warning about these issues for years, Cecala said. "We have regular conversations with Clayton and Clayton would make the claim that they were seeing a lot of bad loans in their examinations and not many people were acting on it," Cecala said. "And clearly, the only way we could have the problems that we experienced is if people actually ignored problems. It's not like these were bad loans that suddenly turned bad. There were problems from day one and someone should have known it.

"Clayton was very frustrated that a lot of people never really acted on [their findings]," said Cecala. "Clayton would report that a lot of times they found problems in loan samples and not only did the issuer not want them to sample any more, which would have cost more money, but they didn't act on the information they uncovered." Issuers, which hired Clayton to perform due diligence, didn't want to pay for more sampling. They also wanted to pump out as many deals as quickly as possible, Cecala added. But, he cautioned, investors weren't necessarily paying attention to these kinds of details.

"Keep in mind that investors ultimately bought a deal almost exclusively based on the rating, and not the issuer's decision [regarding] what loans to put in or what loans not to put in," Cecala said. "Historically there's been very little recourse back to the issuer for problems with securities down the road and the bottom line is if you can get it past the ratings services you're more or less home free."

The three big credit rating agencies that dominate the market -- Standard and Poor's, Moody's Investors Service and Fitch Ratings -- had a chance to use Clayton's information during this time, but declined, Johnson testified. He told the crisis commission that Clayton had meetings with S&P in 2006 and with Fitch and Moody's in 2007. "All of them thought this was great," Johnson testified.

But the rating agencies declined. The reason why, Johnson said, was because if a rating agency bought Clayton's services it would have likely been more stringent. That, in turn, would cause it to lose market share because Wall Street issuers would have just gone to an easier rating agency. The rating agencies began requiring such third-party due diligence in 2007 after a state attorney general stepped in, Johnson said. By then, though, it was too late.

"Keep in mind that the rating services basically based a lot of their rating decisions not on an examination of every loan or the collateral, but basically on representations from the issuer," Cecala said. "That was the system we had in place." Cecala said it was "highly unlikely" that Wall Street firms shared Clayton's findings with the rating agencies. "We could have... stopped the factory from producing," Johnson lamented.

US Treasury stumbles selling Citi shares
by Francesco Guerrera - Financial Times

The US government is in danger of missing its deadline of divesting all of its Citigroup shares by the year-end after a fall in stock market trading volumes prompted authorities to slow down sales in July and August. The lull could prompt the US Treasury, which has a stake of about 17 per cent in Citi, to consider a share offering instead of selling the stock in small quantities in the market, according to bankers and analysts.

"The sales of Citigroup stock have slowed way down in July and August...The US Treasury will not finish its share sale by...the end of the year," said Linus Wilson, a professor of finance at the University of Louisiana. "The only option for the Treasury if it wants to exit Citigroup before the year-end seems to be to conduct a large secondary offering of the stake."

The government only seeks to sell shares equivalent to a small percentage of the overall trading volume in Citi to avoid depressing the price. By the end of August, less than half of the government’s 7.7bn shares in Citi had been sold, with the average number of shares sold per day falling sharply, the latest official data show. The Treasury has until Thursday to complete the sale of 1.5bn shares before entering a "blackout period" ahead of Citi’s third-quarter results.

Missing the December deadline would not have a great financial impact on the Treasury, which has already made a profit of more than $2bn on the Citi investment. But the delay would be emblematic of the difficulties faced by the authorities as they extricate themselves from the aid doled out during the crisis. Two years after Washington injected billions of dollars into banks, insurers and carmakers through the troubled asset relief programme, Citi and the insurer AIG remain the two largest groups yet to repay taxpayers.

The government’s continued involvement complicates Citi’s efforts to convince investors its troubled past is behind it. Citi shares have risen nearly 18 per cent this year but volumes have fallen in line with the market during the summer. By the end of August, Treasury has sold 3.5bn of the 7.7bn shares it received last year when it converted $25bn-worth of preferred shares, netting a profit of more than $2.6bn, according to Prof Wilson. The shares were part of a $45bn in rescue aid received by Citi during the crisis.

The sale of the latest tranche began on July 23 when Treasury said it had authorized Morgan Stanley to sell 1.5bn shares in the market. By the end of August, though, the authorities had sold just 900m. The average number of shares sold in the period was about 33.5m compared with a peak of 66m a day in April and May.

Euroland Should Prepare for More Ups and Downs in Its Yo-Yo Economy
by Irwin Stelzer - Wall Street Journal

Cheer at a bit of good news, and it is soon overtaken by bad news. That seems to be the story of euroland.
  • Ireland reassures the markets by bailing out its banks. Good news. Ireland goes to the markets to raise money and pays four percentage points over bunds. Bad news.
  • High earnings lift sentiment in Germany reports Commerzbank. Good news. Sentiment in the financial community in Germany drops again as a slump is expected, reports Commerzbank. Bad news.
  • Spanish Prime Minister José Luis Rodríguez Zapatero tells this newspaper, "I believe that the debt crisis… has passed." Very good news. Despite paying exorbitant interest rates, Portugal, which hasn't done very much to reduce its budget deficit, can persuade investors to buy only €750 million ($1.01 billion) of its debt, the low end of its €1 billion goal and, along with Ireland, might have to join Greece in seeking emergency financial aid. Very bad news.

I could continue this yo-yo description of euroland affairs were it not that I will run out of good news to juxtapose against the bad. The slowdown in America means that this engine of worldwide growth is at least for now on the sidings. And any thought that Europe's economy had decoupled from America's is now seen as wishful thinking.

More important even than the bad news from America is the news coming out of euroland. It is not only that some countries—Portugal being the leading example—are having trouble putting austerity plans into action. That would be bad enough. But the European Central Bank demands more spending cuts. "Credible and ambitious consolidation raises expectations of future economic growth…" it insists.

Ireland, trying mightily to satisfy the ECB, is finding that cutting spending and raising taxes might just be producing the downward spiral that American President Barack Obama and Britain's shadow-chancellor-in-waiting Ed Balls have been warning about. Ireland is cutting spending, but either because of those cuts, or in spite of them, its economy is contracting at an annual rate of close to 5%.

That reduces tax revenues, adds to social spending, and—as John Maynard Keynes might have advised were he still with us—will make it highly unlikely that Ireland will reach its goal of reducing its deficit from 11.6% of GDP (not counting bank bailouts) to 3% by 2014. James Nixon, chief European economist for Société Générale, told the Times of London that unless Ireland gets an €80 billion bailout, its public finances are condemned to a "long, arduous, slow death."

There is worse. If Ireland and Portugal do queue up behind Greece, begging bowls rattling, they will be doing so at a time when their euroland colleagues, facing an EU-wide slow-down, will be most unhappy about bailing them out.

Greece has already locked in a €110 billion rescue package from the European Financial Stability Fund, and estimates are that Portugal (€70 billion) and Ireland (€80 billion) would bring the demand on the EFSF to €260 billion—unless Spain, with unemployment above 20% and its regional banks, or cajas, reeling under the burden of duff property loans, joins the hand-out queue. That is not far from the limit of the guarantee capacity of the EFSF, once a variety of mandated reserves and deductions from its theoretical €440 billion in available funds are factored in.

Most of these problems could be more easily resolved if only growth in the euro zone were as robust as it was only a few months ago. But the Purchasing Mangers' Index for both the service and the manufacturing sectors dropped this month, although remaining about the 50 level that signals growth. So it is to be slow growth for the euro zone as a whole, with Germany pulling the area economy forward with less force, against the increasing drag created by problems in the peripheral economies.

The reasons for Germany's reduced ability to power euroarea growth are two. For one thing, its exports are likely to be hurt by the U.S. slowdown and the recent fall in the dollar. For another, German banks will have to reduce lending sharply, by an estimated one-third in the case of local banks—to conform to the new Basel III capital-adequacy rules.

But fear not. When (1) the taskforce headed by European Council President Herman Van Rompuy finishes reviewing (2) the proposals to fine profligate countries, to be unveiled next week by Olli Rehn, European commissioner for economic and monetary affairs, and (3) the proposals are debated in and presumably approved by the European Parliament, all will be well. Assuming of course (4) that Germany, which wants to revise the Lisbon Treaty to apply the new rules EU-wide, and France, which wants nothing to do with a re-opening of the Treaty and therefore wants the fines to apply only in euroland, can resolve their differences. The mills of Brussels grind slowly indeed.

On the Secret Committee to Save the Euro, a Dangerous Divide
by Marcus Walker, Charles Forelle and Brian Blackstone - Wall Street Journal

Two months after Lehman Brothers collapsed in the fall of 2008, a small group of European leaders set up a secret task force—one so secret that they dubbed it "the group that doesn't exist." Its mission: Devise a plan to head off a default by a country in the 16-nation euro zone.

When Greece ran into trouble a year later, the conclave, whose existence has never before been reported, had yet to agree on a strategy. In a prelude to a cantankerous public debate that would later delay Europe's response to the euro-zone debt crisis until the eleventh hour, the task force struggled to surmount broad disagreement over whether and how the euro zone should rescue one of its own. It never found the answer.

A Wall Street Journal investigation, based on dozens of interviews with officials from around the EU, reveals that the divisions that bedeviled the task force pushed the currency union perilously close to collapse. In early May, just hours before Germany and France broke their stalemate and agreed to endorse a trillion-dollar fund to rescue troubled euro-zone members, French Finance Minister Christine Lagarde told her delegation the euro zone was on the verge of breaking apart, according to people familiar with the matter.

The euro zone's near death had stakes for people around the world. A wave of government defaults on Europe's periphery could have triggered a new crisis in the international banking system, with even worse consequences for the global economy than the failure of Lehman.

The dangerous dithering was driven by ideological divisions that continue to paralyze the currency union's search for solutions to its structural flaws. Deep differences on economic policy between Europe's frugal north and laxer south, between Germany and France, and between national governments and central EU institutions hindered an effective early response to the crisis. Only when faced with calamity—the collapse of the euro zone—did leaders put aside their differences and reach a compromise. Complicating matters: The two most important politicians deciding the fate of the euro often had conflicting agendas—and much at stake personally.

French President Nicolas Sarkozy, known in France as the "hyper-president" for his relentless flurry of new initiatives, faced declining approval ratings as his domestic economic overhaul stalled. The excitable 55-year-old leader saw that Greece's woes could rock the euro zone. Mr. Sarkozy seized on the issue as an opportunity to prove his leadership chops and thus shore up his popularity.

For German Chancellor Angela Merkel, 56, the crisis was the biggest test of her career. A trained physicist known for her cautious, deliberative style, she feared a backlash from German voters and lawmakers, and defeat in Germany's supreme court, if she risked taxpayer money on serial deficit-sinner Greece. Despite pressure from Mr. Sarkozy, she fiercely resisted a quick fix. When Mr. Sarkozy barreled into one meeting with camera crews and photographers in tow, Ms. Merkel icily ordered the cameras out: "I won't let you do this to me," she said, warning she wouldn't play the part of "the stubborn old bag."

Europe eventually did establish a rescue fund in May. By then the price of calm had soared, requiring a pledge of €750 billion. It defused the panic but hasn't snuffed out the crisis: Unsustainable borrowing still poses huge challenges, especially in Greece and Ireland. The danger of a government-debt crisis in the euro zone began to preoccupy top European policy makers in October 2008. Hungary, an EU member which doesn't use the euro, found itself unable to sell bonds to jittery investors. The EU, using an existing but little-used program, and the International Monetary Fund and World Bank swiftly propped up Hungary by pledging about €20 billion in loans.

But it soon became apparent that the euro zone had no tools to save one of its own. EU treaties made clear the facility used for Hungary was off limits to euro members. For most EU officials, the IMF was taboo, too: Its loans were fine for poor ex-Communist nations, they felt, but not for developed euro members.

In March 2009, French Treasury official Xavier Musca was preparing to step down as chairman of the Economic and Financial Committee, an influential body of technocrats who manage EU economic policy. He briefed his successor, Thomas Wieser of Austria, on the duties. At the end of a long list, he added one more. "Incidentally," Mr. Musca said, "there's a group that doesn't exist."

The secret task force, coordinated by the committee chairman, had been meeting surreptitiously since November 2008 to craft a plan should a Hungary-style crisis strike a euro nation. Membership was limited to senior policy makers—usually just below ministerial level—from France, Germany, the European Commission, Europe's central bank and the office of Jean-Claude Juncker, the Luxembourg premier who heads an assembly of euro finance ministers.

The task force met in the shadows of the EU's many councils and summits in Brussels, Luxembourg and other capitals, often gathering at 6 a.m. or huddling over sandwiches late at night. Participants kept colleagues in their own governments in the dark, for fear leaks would trigger rampant speculation in financial markets. Potential crisis candidates were obvious: Portugal, Ireland, Greece and Spain, a group of deeply indebted states derisively tagged with the acronym "PIGS" by bond traders.

A gap quickly opened up between Germany, attached to euro-zone rules it viewed as banning bailouts for profligate countries, and France, which wanted greater freedom for national governments to support each other as they saw fit. A fault line also developed over whether EU institutions should run any bailout operation. The European Commission, the union's executive branch, pushed for a central role in raising and lending funds—and found an ally in France. Germany, wary of a power grab, was deeply reluctant to put its cash in Brussels' hands.

The German finance ministry feared the commission was trying to establish a precedent for centralized European public borrowing, through EU bonds. That would imply Germany, Europe's strongest creditor, subsidizing other nations. Instead, Germany insisted any aid must come via loans by the individual euro-zone members to a stricken country. That way Berlin, writer of the biggest check, could control the process and force a wayward recipient to reform itself. The philosophical divide among task-force members persisted for nearly a year. Last October, it ceased to be academic.

That month, Greece's newly elected Socialist government declared the country's 2009 budget deficit was heading for 12.5% of gross domestic product—more than three times the previous government's official forecast. Stunned investors began to dump Greek bonds. Greece faced daunting debt repayments in spring 2010, and it wasn't at all clear if it would have the money to make them.

By February, it became obvious that the 16-nation euro zone would have to do something to address the Greek bond meltdown. The secret task force of France, Germany and EU bureaucrats opened its doors to the rest of the member countries—except Greece. A summit of EU leaders had been planned for Feb. 11 to mull Europe's long-term economic goals. Governments insisted publicly that Greece was "not on the agenda." The hope, say aides to several European leaders, was that if Europe didn't upset the markets by talking about the matter, Greece might be able to sell enough bonds to escape trouble.

But Greek bond prices—a key measure of investor confidence—began plunging in the days before the meeting. Luxembourg's Mr. Juncker convened an emergency teleconference of euro-zone finance ministers on the eve of the summit. They agreed on a statement to be read at the summit's conclusion pledging "support" for Greece.

In Berlin's austere chancellery building, Ms. Merkel wasn't happy. Her advisers were telling her that Greece's problems ran deeper than a short-term cash shortage: The country was economically uncompetitive and living beyond its means. Without a deep overhaul, a quick-fix bailout would keep Greece afloat for only a few months, they warned. In addition, Germany's supreme court would strike down a bailout, the advisers warned, unless it was absolutely unavoidable.

Deep in the night, Ms. Merkel called other leaders, including President Sarkozy, and made it clear she would veto any promise of aid for Greece unless Athens took much tougher action to cut its public spending and overhaul its economy. Mr. Sarkozy replied that Greek Prime Minister George Papandreou was already taking brave action. "Now it is time for Europe to help," he said. "The financial markets will say this is not a solution," Ms. Merkel told the French leader.

The next day's summit, on a Thursday, was scheduled for 10:15 a.m. at the Bibliotheque Solvay, a historic library on a Brussels hilltop. Late Wednesday, EU President Herman Van Rompuy of Belgium postponed it by more than two hours. Snowy weather was the official explanation given for the delay. In reality, Mr. Van Rompuy huddled that morning in his office on the fifth floor of the EU's summit building with a few key leaders—including Ms. Merkel, Mr. Sarkozy and the head of the European Central Bank, Jean-Claude Trichet. Other European leaders were cooling their heels at the library. On currency markets, the euro was gyrating in anticipation of a bold rescue—or a bust.

Mr. Sarkozy pushed the chancellor for a clear public declaration that Europe stood behind Greece. "I cannot buy that," Ms. Merkel responded. Eventually, Mr. Van Rompuy brokered a compromise, in the form of a nine-word sentence tacked on to a statement aides were scribbling out on a conference table: "The Greek government has not requested any financial support." The language sneaked in a back-door mention of Greece, but it conformed to Ms. Merkel's insistence that the country not be offered any help. She had won the round.

Other European leaders believed Ms. Merkel was playing for time because of domestic politics. Her center-right coalition faced a crucial regional election on May 9 in North Rhine-Westphalia, Germany's most populous state. Opinion polls showed voters were furious about the prospect of bailing out the profligate Greeks. "It was clear that the election was playing a big role," says the finance minister of another euro-zone country. Spokesmen for Ms. Merkel strenuously deny that North Rhine-Westphalia influenced her tactics on Greece.

The chancellor struggled to rein in speculation about an imminent bailout one Friday in late February, when the head of Germany's biggest bank, Deutsche Bank Chief Executive Josef Ackermann, mysteriously appeared in Athens for consultations with Greek leaders. Mr. Ackermann had an idea for supplying Greece with up to €30 billion of credit—half from Germany and France, half from major European banks.

In a phone call from Athens that day, Mr. Ackermann pitched the proposal to Ms. Merkel's chief economic adviser, Jens Weidmann. The reply: unacceptable. "You cannot tell the Greeks that this is a German government offer," Mr. Weidmann said, fearing the already-widespread impression that Mr. Ackermann was acting as a go-between. A posse of cameras met Mr. Ackermann when he emerged from the Greek parliament building. "I'm regularly in Greece because I love Greece and the beautiful weather," a grinning Mr. Ackermann said, before disappearing into his armored Mercedes-Benz.

By mid-March, Greek Premier Papandreou was clamoring openly for Europe to reassure markets by putting money on the table. Ms. Merkel went on German public radio that month and said Greece didn't need aid. An upcoming EU summit should focus on other issues—and other European leaders shouldn't stir up "false expectations," she said. But behind the scenes, Ms. Merkel was starting to take over the contingency planning.

There was one thing the secret task force had agreed on: Europe, not the IMF, would handle any bailout. The German finance ministry felt the same. Involving the Washington-based fund in a bailout of Greece would be an admission of European weakness, Finance Minister Wolfgang Schäuble said publicly. Mr. Sarkozy, Mr. Juncker and ECB chief Trichet all shared that view strongly.

Ms. Merkel, however, overruled them all. Her advisers were telling her that aid to Greece could be sold to her skeptical countrymen only as part of a wrenching IMF program of economic adjustment for Greece. IMF-inflicted pain would also deter other indebted euro-zone countries from seeking aid. The disagreement came to a head before the broader EU's regular spring summit in Brussels on March 25.

That afternoon, before all 27 leaders gathered, Ms. Merkel met Mr. Sarkozy in one of the many spartan meeting rooms in the EU's warren-like headquarters. The chancellor agreed to announce that the euro zone would rescue Greece if it faced default—but only as a last resort, once Greece had exhausted its access to capital markets. Also, the IMF must be part of any loan package, and the IMF—not the European Commission—should draw up Greece's program of overhauls, she said.

Mr. Sarkozy protested against involving the IMF, whose biggest shareholder is the U.S. government. Europe cannot let "the Americans" decide who gets credit in Europe, he said.
Ms. Merkel put her foot down, insisting that only the IMF had the necessary experience. Mr. Sarkozy, recognizing that Germany's financial muscle was essential for any bailout, reluctantly gave way.

On April 11, with the crisis of investor confidence spreading from Greek government bonds to the country's banking system, the EU finally put money on the table. As Germany wanted, the €30 billion for the first year would come in the form of 15 separate government-to-government loans, while the IMF would lend another €15 billion. Officials hoped the sum, enough to cover Greece's borrowing needs for less than a year, would be enough to calm markets. It wasn't.

Hostilities escalate to hidden currency war
by Alan Beattie - Financial Times

Everyone has been thinking it, but Guido Mantega, the Brazilian finance minister, has been one of the few policy makers publicly to admit it. His assertion that there is a currency war going on follows a recent escalation of competitive intervention in the foreign exchange markets, with heavyweight powers armed with serious weaponry getting involved. 

Although some argue that a generalised burst of foreign exchange intervention could act as a global monetary easing, a more widespread view is that such a round of competitive devaluation is more likely to inflame international tensions. It was a symbolic moment when Japan this month ended its six-year abstinence from intervening in the foreign exchange markets andsold an estimated $20bn of yen. Japan is the only one of the large industrialised Group of Seven economies regularly to have used currency intervention over the past 20 years. But its traditional rationale – that interest rates were so close to zero that conventional monetary policy was losing its strength – now applies to many more countries.

Aside from China, whose intervention is one of the main causes of the global currency battle, several big economies have been intervening for some time. Switzerland started unilateral intervention against the Swiss franc last year for the first time since 2002 and did not sterilise it by buying back in the domestic money markets what it had sold across the foreign exchanges. 

In common with several east Asian countries, South Korea, host of the Group of 20 summit, has been intervening intermittently to hold down the won during the course of this year. Deliberately weakening a currency while running a strong current account surplus has raised eyebrows in Washington. Recently it was revealed that Brazil itself, which has been expressing concern since last year about inflows of hot money pushing up the real and unbalancing the economy, had given authority to its sovereign wealth fund to sell the real on its behalf.

The resort to unilateralism bodes ill for US hopes of assembling an international coalition of countries at the forthcoming G20 meeting to put pressure on China over its interventions to prevent the renminbi rising. While most of the countries currently intervening would be likely to welcome a revaluation of the renminbi, few emerging market governments seem to want to stand up to China publicly – barring sporadic criticism such as that from Brazilian and Indian central bankers earlier this year. 

Last week Celso Amorim, Brazil’s foreign minister, said that he did not want to become part of an organised campaign. Following a meeting of the Brics countries – Brazil, Russia, India and China – in New York, he told Reuters: "I believe that this idea of putting pressure on a country is not the right way for finding solutions."

Mr Amorim added: "We have good co-ordination with China and we’ve been talking to them. We can’t forget that China is currently our main customer." Brazil exports commodities to China. Some, such as the Berkeley economist Barry Eichengreen, argue that attempts at competitive devaluation may not be a bad thing. If countries are essentially creating more of their own currency to sell, that in effect means they are loosening monetary policy.

So a round of attempted devaluations, rather than being a zero-sum game, could end up as a form of semi-co ordinated monetary easing. But others warn that this rosy scenario ignores the confusion that may arise when every country is intervening against its own currency in the foreign exchange markets, conveying a spirit of competition rather than co-operation. Ted Truman, a former US Treasury and Federal Reserve official now at the Peterson Institute in Washington, says: "Mixing up intervention and monetary policy can be dangerous. Trying to calibrate the extent of intervention is going to be very hard when people don’t really know what they are doing."

Mr Truman says that given the weak global recovery there may be a case for central banks to move towards quantitative easing, seeking to boost the money supply further. But he says it is far better for each country to do so in its own domestic money markets than by intervening in the currency markets. For the moment, co-ordination seems further away than ever. And since every country cannot devalue at the same time, and given that some authorities – such as the Europeans and Americans – are generally less willing than others to intervene to suppress their currencies, more competitive devaluation could provoke sharp and destabilising movements in currencies.

Gold is the final refuge against universal currency debasement
by Ambrose Evans-Pritchard - Telegraph

States accounting for two-thirds of the global economy are either holding down their exchange rates by direct intervention or steering currencies lower in an attempt to shift problems on to somebody else, each with their own plausible justification. Nothing like this has been seen since the 1930s.
"We live in an amazing world. Everybody has big budget deficits and big easy money but somehow the world as a whole cannot fully employ itself," said former Fed chair Paul Volcker in Chris Whalen’s new book Inflated: How Money and Debt Built the American Dream. "It is a serious question. We are no longer talking about a single country having a big depression but the entire world."
The US and Britain are debasing coinage to alleviate the pain of debt-busts, and to revive their export industries: China is debasing to off-load its manufacturing overcapacity on to the rest of the world, though it has a trade surplus with the US of $20bn (£12.6bn) a month. Premier Wen Jiabao confesses that China’s ability to maintain social order depends on a suppressed currency. A 20pc revaluation would be unbearable. "I can’t imagine how many Chinese factories will go bankrupt, how many Chinese workers will lose their jobs," he said.

Plead he might, but tempers in Washington are rising. Congress will vote next week on the Currency Reform for Fair Trade Act, intended to make it much harder for the Commerce Department to avoid imposing "remedial tariffs" on Chinese goods deemed to be receiving "benefit" from an unduly weak currency. Japan has intervened to stop the strong yen tipping the country into a deflation death spiral, though it too has a trade surplus. There is suspicion in Tokyo that Beijing’s record purchase of Japanese debt in June, July, and August was not entirely friendly, intended to secure yuan-yen advantage and perhaps to damage Japan’s industry at a time of escalating strategic tensions in the Pacific region.

Brazil dived into the markets on Friday to weaken the real. The Swiss have been doing it for months, accumulating reserves equal to 40pc of GDP in a forlorn attempt to stem capital flight from Euroland. Like the Chinese and Japanese, they too are battling to stop the rest of the world taking away their structural surplus. The exception is Germany, which protects its surplus ($179bn, or 5.2pc of GDP) by means of an undervalued exchange rate within EMU. The global game of pass the unemployment parcel has to end somewhere. It ends in Greece, Portugal, Spain, Ireland, parts of Eastern Europe, and will end in France and Italy too, at least until their democracies object.

It is no mystery why so many states around the world are trying to steal a march on others by debasement, or to stop debasers stealing a march on them. The three pillars of global demand at the height of the credit bubble in 2007 were – by deficits – the US ($793bn), Spain ($126bn), UK ($87bn). These have shrunk to $431bn, $75bn, and $33bn respectively as we sinners tighten our belts in the aftermath of debt bubbles.. The Brazils and Indias of the world are replacing some of this half trillion lost juice, but not all.

East Asia’s surplus states seem structurally incapable of compensating for austerity in the West, whether because of the Confucian saving ethic, or the habits of mercantilist practice, or in China’s case by the lack of a welfare net. Their export models rely on the willingness of Anglo-PIGS to bankrupt themselves.

So we have an early 1930s world where surplus states are hoarding money, instead of recycling it. A solution of sorts in the Great Depression was for each deficit country to devalue, breaking out of the trap (then enforced by the Gold Standard). This turned the deflation tables on the surplus powers – France and the US from 1929-1931 – forcing them to reflate as well (the US in 1933) or collapse (France in 1936). Contrary to myth, beggar-thy-neighbour policy was the global cure.

A variant of this may now occur. If China continues to hold down its currency, the country will import excess US liquidity, overheat, and lose wage competitiveness. This is the default cure if all else fails, and I believe it is well under way. The latest Fed minutes are remarkable. They add a new doctrine, that a fresh monetary blitz – or QE2 – will be used to stop inflation falling much below 1.5pc. Surely the Fed has not become so reckless that it really aims to use emergency measures to create inflation, rather preventing deflation? This must be a cover-story. Ben Bernanke’s real purpose – as he aired in his November 2002 speech on deflation – is to weaken the dollar.

If so, he has succeeded. The Swiss franc smashed through parity last week as investors digested the message. But the swissie is an over-rated refuge. The franc cannot go much further without destabilizing Switzerland itself. Gold has no such limits. It hit $1300 an ounce last week, still well shy of the $2,200-2,400 range reached in the late Medieval era of the 14th and 15th Centuries.

This is not to say that gold has any particular "intrinsic value"’. It is subject to supply and demand like everything else. It crashed after the gold discoveries of Spain’s Conquistadores in the New World, and slid further after finds in Australia and South Africa. It ultimately lost 90pc of its value – hitting rock-bottom a decade ago when central banks succumbed to fiat hubris and began to sell their bullion. Gold hit a millennium-low on the day that Gordon Brown auctioned the first tranche of Britain’s gold. It has risen five-fold since then.

We have a new world order where China and India are buying gold on every dip, where the West faces an ageing crisis, and where the sovereign states of the US, Japan, and most of Western Europe have public debt trajectories near or beyond the point of no return.

The managers of all four reserve currencies are playing fast and loose: the Fed is clipping the dollar; the Bank of England is clipping sterling; the European Central Bank is buying the bonds of EMU debtors to stave off insolvency, something it vowed never to do just months ago; and the Bank of Japan has just carried out two trillion yen of "unsterilized" intervention. Of course, gold can go higher.

Banks Keep Failing, No End in Sight
by Randall Smith and Robin Sidel - Wall Street Journal

Since WaMu Fell, 279 Lenders Have Collapsed; Lost Jobs, Curtailed Lending and the Big Get Bigger

The largest number of bank failures in nearly 20 years has eliminated jobs, accelerated a drought in lending and left the industry's survivors with more power to squeeze customers. Some 279 banks have collapsed since Sept. 25, 2008, when Washington Mutual Inc. became the biggest bank failure on record. That dwarfed the 1984 demise of Continental Illinois, which had only one-seventh of WaMu's assets. The failures of the past two years shattered the pace of the prior six-year period, when only three dozen banks died.

Two more banks went down last Friday, and failures are expected to "persist for some time," according to a report issued Tuesday by Standard & Poor's. In the second quarter of this year, the Federal Deposit Insurance Corp. increased its number of problem banks by 6% to 829. Between failures and consolidation, the number of U.S. banks could fall to 5,000 over the next decade from the current 7,932, according to the top executive of investment-banking firm Keefe, Bruyette & Woods Inc.

The upside of failures is that they can represent a healthy cleansing of a sector that grew too fast, with bank assets more than doubling to $13.8 trillion in the decade that ended in 2008. Many banks that failed were opportunistic latecomers. Of the failed banks since February 2007, 75 were formed after 1999, according to SNL Financial.

Still, economists say, the contraction represents an enduring threat to capital, lending and the economy. "When we step back and look at this financial disaster 10 years from now, the destruction of capital in our economy as a result of what we've endured will be the single greatest lasting impact on recovery and how the economy performs in the future," says Howard Headlee, president of the Utah Bankers Association.

The pain is less severe than in the Japanese banking crisis, in which banks languished for a decade despite $440 billion the government spent to assist the industry.
But, in the past two years, the whole U.S. banking system recoiled. Large banks like Countrywide Financial Corp. and Wachovia Corp. were acquired to avert failure while powerful banks including Citigroup Inc. and Bank of America Corp. were propped up by the government.

Between the failures and government assistance, Gerard Cassidy of RBC Capital Markets says, the impact to the system has been "far more severe" than the savings-and-loan crisis. Not only were government rescue measures more sweeping and more global this time, the weakness in real estate continues to constrain economic growth.
Since 2008, the industry's assets have shrunk by 4.5%. "If you reduce the amount of assets at a bank, it means they make fewer loans, and that has a negative impact on the economy," says Richard Bove, a bank analyst at Rochdale Securities in Lutz, Fla.

From small towns like Rockford, Ill., to Miami, the banks' disappearance means not only cutbacks in lending but fewer banking choices, lower interest rates on savings accounts, and lost jobs. The recession and collapse of the housing bubble have cut bank-industry employment by 188,000 jobs, or 8.5%, since 2007, according to FDIC data. Failures alone have cost 11,210 jobs, or 32% of the employees at failed banks, according to FIG Partners, an Atlanta investment firm that specializes in the banking industry.

For more than a year, Martin Quantz and his co-workers at the Woodstock, Ill. branch of Amcore Bank checked the FDIC's website each Friday afternoon to see if their flailing bank had gone under. Regulators seized the bank in April and turned over its 58 branches to Harris National Association. By August, Mr. Quantz was unemployed. He now hopes reconnecting with an old contact will lead to a new bank job. "There's a lot of pain out there, and there are a lot of people in the industry who won't go back," says Mr. Quantz, 41 years old.

The city of Clinton, Utah, may never be refunded $83,000, a portion of their cemetery-maintenance funds that wasn't insured when nearby Centennial Bank failed without a buyer. In nearby Ogden, Utah, Weber State University lost $100,000 in scholarship money that had been pledged by Barnes Banking Co., a 119-year-old local institution that failed in January. The scholarships, to be distributed in $1,000 increments, represented one quarter of in-state tuition, says a Weber State administrator. Earlier this month, the college restored the Barnes Banking Lecture Hall to its original name: "Room 110."

Failed bank assets are now strewn across the banking system. The FDIC is burdened with $38 billion of remnants it is trying to sell. They range from virtually worthless mortgaged-backed securities to office decorations such as plastic Christmas trees. The tough times follow cresting prosperity in which banks with few loan losses chased customers into hot real-estate markets. When the subprime mortgage bubble burst, failures were concentrated among mortgage lenders such as IndyMac Bank, which left $1 billion of depositors' money uninsured when it failed in 2008.

Various autopsies of expired banks all point to real estate as the primary cause. A tally by SNL Financial LC found that 94% of bank failures since 2008 had either residential or commercial real-estate as their largest category of delinquent loans. KBW says their riskier construction loans were 23% of their total portfolio, compared with 7.2% for the industry as a whole. The delinquency rate of commercial real estate was 13.5%, far above the current national average of 1.7%, SNL said.

The Imperial Capital Bank unit of Imperial Capital Bancorp in La Jolla, Calif., specialized in real estate. Like many other small banks, it extended beyond its home turf and made loans nationwide. The bank more than doubled its assets to $4.1 billion in the five years ended in 2008, according to an FDIC report. Then, the nine-branch bank purchased $826 million of mortgage-backed securities. Real estate accounted for more than 95% of its loans, compared to 35% or less for its peers. The bank failed in 2009.

Some economists argue that, for all the damage, the failures' impact on the economy was muted because the largest banks that failed or came close were quickly absorbed by other institutions or helped by the government. "I don't think enough banks have failed, or have been failing fast enough, to have a macro-economic impact," says economist Edward Yardeni. Surviving banks have raised more than $500 billion in new capital, reducing the risks of new failures by boosting rainy-day funds. Failure can occasionally jumpstart lending. To conserve capital, regulators often block sickly banks from making new loans. When a bank buys the assets of the failed institution, that buyer often resumes lending.

Since acquiring operations of the failed Frontier Bank in Everett, Wash., last April, Union Bank N.A. has started originating loans in Frontier's region in western Washington and Oregon. Though Union lowered interest rates on certificates of deposit, "We desire to grow our loan portfolio and are eager to find ways to make loans that make sense," says Tim Wennes, chief retail banking officer for Union Bank, a unit of San Francisco-based UnionBanCal Corp.

Such consolidation also means the biggest are getting bigger: Bank of America, J.P. Morgan Chase & Co. and Wells Fargo hold 33% of all U.S. deposits, up from 21% in 2006, according to SNL Financial. That gives them more market power to squeeze out smaller competitors.

John Squires, who was chief executive officer of Old Southern Bank when it failed in March, protests that his larger competitors in his Orlando, Fla., neighborhood all survived thanks to heavy doses of government support, which allowed them to raise capital more easily. "Absolutely unfair—the big boys have the clout," says Mr. Squires. "Community banks are in jeopardy all over the country."

Anglo Irish Cost May Exceed €35 Billion
by Finbarr Flynn and Louisa Fahy - Bloomberg

Anglo Irish Bank Corp.’s bailout may cost Ireland’s government more than 35 billion-euro ($47 billion), Standard & Poor’s credit analyst Trevor Cullinan said, exceeding the rating company’s previous estimate. "Estimates which were previously strongly against our 35 billion euro now seem to be coming in line with that recapitalization cost," Cullinan said in an interview broadcast by Dublin’s RTE Radio today. "So the government’s kind of Plan B with Anglo means this 35 billion euros could even be exceeded."

Ireland’s financial regulator is due this week to release an estimate for recapitalizing the state-owned lender as it’s split into a deposit bank and an asset-recovery unit. Irish bonds dropped today, pushing the extra yield that investors demand to hold the country’s 10-year debt over German bunds to a record 452 basis points. "The sell-off seems to be triggered by the S&P remarks," Fergal O’Leary, a director at Dublin-based Glas Securities, which specializes in fixed-income markets. "S&P’s previous estimate of 35 billion euros was at the upper end of market expectations. Any suggestion that this could be raised is a concern."

S&P lowered Ireland’s credit rating to ‘AA-’ on August 24, warning of further possible downgrades. The ratings company said yesterday it doesn’t expect Ireland to default on its debts. Anglo won’t need more than 29 billion euros, two people with knowledge of the matter said last week. If the 35 billion-euro estimate is exceeded, "there potentially could be further downward rating actions from Standard & Poor’s," said Cullinan.

Anglo Irish’s senior debt was yesterday cut to the lowest investment grade rating by Moody’s Investors Service, which said it may reduce the rating to junk unless the government guarantees bondholders against losses. Anglo Irish’s subordinated debt, guaranteed by Ireland’s government until Sept. 29, was downgraded to Caa1 from Ba1. The Irish government appears to "remain resolute that there will be no renegotiation" with Anglo Irish’s senior bondholders, Goodbody Stockbrokers said in a note to clients today.

The cost of credit-default swaps to insure the senior debt of Anglo Irish rose 5 basis points today to a record 941 basis points, according to data provider CMA. The contracts have more than doubled since July, CMA prices show. Credit-default swaps on Irish government debt rose 31 basis points to 519, according to CMA.

Ireland’s ISEQ benchmark stock index declined 1.3 percent as of 10:15 a.m. in Dublin trading, lead by a 5.7 percent drop in Allied Irish Banks Plc and a 4.3 percent decline in Bank of Ireland Plc. "It’s all about getting clarity on Anglo at the moment," said O’Leary at Glas.