"Part of an impoverished family of nine on a New Mexico highway. Depression refugees from Iowa. Left Iowa in 1932 because of father's ill health. Father an auto mechanic laborer, painter by trade, tubercular. Family has been on relief in Arizona but refused entry on relief rolls in Iowa to which state they wish to return. Nine children including a sick four-month-old baby. No money at all. About to sell their belongings and trailer for money to buy food. 'We don't want to go where we'll be a nuisance to anybody.'"
Ilargi: I wouldn't have assumed anything different, but I'm sure now. It's really not helpful to have your network disappear for 30 hours straight. Not if you want to do an extensive daily round of reading and writing. Still, a short stint at a loud bar with a working network did leave me with a question that I'll pose to you. To find the answer, I might have had to do some digging, and obviously that wasn't going to happen. And besides, I think it's an interesting enough issue to invite some feedback from you. Do ponder it for a moment though.
The Wall Street Journal ran an article yesterday titled Decade of Debt: $9 Trillion , which addresses the White House and CBO deficit reports that came out this week. The data look pretty grisly to me, and I definitely have the idea that the only reason they get underplayed in the media is that they deal with a future so conveniently far away the human eye finds an excuse for looking the other way. I also think that despite the fact that the numbers are real bad as they are presented, they're still covered by a veneer of, let's say, the kind of hedonistic arithmetic that makes GDP reporting so disputable. The overall picture as I see it reported is the familiar one of: this is troubling, but maybe “they” will find something in the meantime.
Anyway, to get to that question: there's a set of graphs in the WSJ article that looks like this:
What struck me here is that about a year from now, GDP growth is projected as approaching 4%, while at the same time unemployment hovers close to 10%. In fact, unemployment and GDP both rise simultaneously for a while! And when I noticed that, my first thought was: I don't think that is even possible. At least not in this situation. I think perhaps there may have been a short time in the US in the late 1930's where you may have seen something similar, but I wouldn't be too sure. Perhaps in the early 1940's, but a war economy has its own set of rules.
What do you think? Is it realistic to expect a 4% GDP growth with that kind of jobless numbers?
There are of course always a few sidenotes that you must be aware of. First, somewhat curiously, Dennis Lockhart, the President and CEO of the Federal Reserve Bank of Atlanta, said yesterday that the real present US unemployment rate is not 9.4%, as officially reported, but 16%: Real US unemployment rate at 16%: Atlanta Fed President He's talking about the difference between U3 and U6 numbers, of course. If people at his level start going public with this sort of claims, we could be in for interesting times. It would also sort of kill the question, because you'd have a hard time finding any serious voice insisting that GDP can grow at 4% while 1 in 6 members of the working age population can't find a job.
Another point that I think needs far more scrutiny lies in the other side of the deficit reports. That is, in principle government borrowing has no immediate negative effect on the GDP, while when the government spends the money it borrows, that spending does indeed have a positive effect. Most people who follow the economy are by now so familiar with this kind of trickery that it doesn't surprise them anymore, but it still merits pointing out every now and then. The underlying principle is that the government can boost today's economic numbers by in effect spending money that has yet to be earned, by generations that maybe even have yet to be born.
The extent to which government interference influences the housing and mortgage markets is clearly enormous. If home prices were left simply to the markets, they would drop like boulders, which would drag down GDP numbers like there's no tomorrow. There's a report out today that claims second quarter GDP fell only by 1%, but that number has little meaning unless and until the effect of such government intervention is given the prominent place it should rightfully have. And when it is given that place, a 4% GDP growth in 2010 starts to look highly improbable. It's in essence ridiculously bad accounting to pretend you can grow your economy by borrowing money from yourself. If you allow these accounting tricks, the more the government borrows, the higher the growth can be made to look.
When my connection was down yesterday, I -finally- started reading Les Leopold’s "The Looting of America" (Read chapter 1). There is a graph in the book that affects the same issue. If you want to raise GDP with high unemployment numbers, you clearly need to dramatically raise productivity per worker. Leopold shows that productivity and wages rose together from 1947 and 1973, after which they disconnect. Wages today are below 1973 in inflation adjusted dollars, while productivity has indeed gone up a lot. Is that the answer we’re looking for? Or do wages need to rise to raise a GDP that depends for 70% on consumer spending?
With all that in mind, my question should be clear, albeit perhaps a bit more challenging. Is it possible to grow your economy at a 4% rate when 10% of your population in unemployed?
PS: Much obliged: I noticed Michael Panzner ranks The Automatic Earth among his Top 10 Great Financial Blogs
Decade of Debt: $9 Trillion
Plunging tax receipts, soaring spending and a sluggish recovery will push the nation's deficits dramatically higher over the next decade, creating new complications for President Barack Obama's domestic agenda. The deteriorating budget picture, detailed Tuesday in separate White House and congressional reports, comes just as Democrats and Republicans prepare to resume the battle over Democratic plans to spend $1 trillion overhauling the nation's health-care system.
The numbers -- including a White House forecast of $9 trillion in additional debt over the next decade -- could affect Mr. Obama's efforts to increase spending in a host of areas, from education to foreign aid. Some budget experts also reiterated their belief that tax increases may need to hit families that the president has vowed to protect. White House budget director Peter Orszag, in an interview Tuesday, said the deficit projections are "higher than desirable" and the administration is working to bring them down in the 2011 budget proposal due early next year.
Asked if that meant tax changes affecting families earning below $250,000 -- something Mr. Obama has pledged he would avoid -- Mr. Orszag replied: "We're in the midst of putting together the 2011 budget, and we'll have more to say about that later." The deficit projections, from the White House Office of Management and Budget and the nonpartisan Congressional Budget Office, came the same day the president renominated Federal Reserve Chairman Ben S. Bernanke. The deficit numbers complicate Mr. Bernanke's task in navigating the economy toward stability and recovery. Fed officials say the U.S. must show progress on deficit reduction by next year to avoid the possibility of a rise in interest rates, which might be needed otherwise to entice global investors to keep buying U.S.-government bonds.
Big deficits could also weaken the dollar against foreign currencies. That could fuel inflation as the cost of imports rises in dollar terms. The biggest effect of the deficit numbers may be felt on the health-care debate. Deficit worries will force Democrats to put new emphasis on cost-cutting efforts in crafting health legislation, said Sen. Charles E. Schumer (D., N.Y.). Democrats can't afford any "slippage" on their pledge to fully pay for the overhaul, he said. Mr. Orszag said: "We need to change health care in such a way that it reduces health-care spending over time," adding that "the final legislation will do that."
Both sides acknowledged Tuesday that the White House's $9 trillion, 10-year debt projection will likely force Democrats to find new real savings in their health-care bills or risk defeat. "I don't think this is going to bring Republicans to the table," said Rep. Paul Ryan of Wisconsin, the ranking Republican on the House Budget Committee. "I think it will move Democrats away from the table." An administration official said, "One would be very hard-pressed to call a $2 trillion addition to your [10-year deficit] forecast helpful, but this really does heighten the urgency" to tackle the growth in health care.
The Office of Management and Budget revised its May deficit projections to forecast a record, $1.58 trillion deficit for the fiscal year that ends Sept. 30. Spending, much aimed at stabilizing the financial sector and boosting the economy, will rise by 24% this year, the largest increase since 1952 and the height of the Korean War, according to the CBO. Tax revenues will fall 17% from last year's levels, the largest drop since 1932.
Measured against the size of the economy, the deficit will hit 11.2% of the gross domestic product, a level not seen since 1945, although it is an improvement from the $1.84 trillion forecast in May. Over the next decade, however, the White House forecast turned bleak. In effect, the White House economists acknowledged the recession will be far worse than they projected early this year. The deficit will improve only slightly in fiscal 2010, to $1.5 trillion, worse than the $1.3 trillion forecast in May. And it will stay high, adding $9 trillion onto the federal debt through 2019. Borrowing alone will account for 40% of federal revenues in 2010.
"Putting the nation on a sustainable fiscal course will require some combination of lower spending and higher revenues," warned the CBO, whose $7 trillion, 10-year deficit forecast is lower than the White House's mainly because it assumes all of President George W. Bush's tax cuts will expire in 2011, something neither party wants. The White House projection assumes most Bush tax cuts would remain in place.
If anything, the numbers understate the problem, said Douglas Holtz-Eakin, a former CBO director and campaign adviser to Republican Sen. John McCain. The White House forecast assumes the president will secure at least $600 billion in revenue over the next decade from forcing polluters to buy credits to emit gases believed to cause global warming. But a scaled-back version that passed the House would raise a maximum of $450 billion, and prospects for Senate passage are dim.
The White House estimate assumes any health-care plan will not increase the deficit. It provides $622 billion in cuts to Medicare and Medicaid to back that up, cuts some Democrats are balking at. The forecasts come as international lenders, especially China, are growing bolder about questioning whether they will keep buying U.S. government debt at today's voracious levels, at least without a big increase in the interest rates paid out by the bonds. Rising rates would make the U.S. government's borrowing costs much higher.
The spending surge this year doesn't stem from a permanent expansion of government. Of the $700 billion increase in spending that the CBO forecasts for fiscal 2009, ending Sept. 30, $424 billion comes from the Troubled Asset Relief Program and the rescue of mortgage giants Fannie Mae and Freddie Mac, bailouts approved under Mr. Bush. About $115 billion stems from Mr. Obama's stimulus plan. The rest comes from increases in spending on Medicaid, unemployment and other programs that rise automatically in an economic downturn. Beyond 2013, deficits will remain stubbornly high in large part because of spending on Medicare, Medicaid and Social Security. That isn't tied to the recession, the CBO said; it will simply rise as baby boomers age.
Questions over strength of recovery
Amid the thin trading volumes of a typically sluggish August, investors have been caught off balance as the normal relationships between US equities, government bonds and commodity prices have broken down. At the end of July, the S&P?500 equity composite was below 1,000 points and the price of crude oil loitered below $70 a barrel. During August, the S&P and oil have risen to their highest levels in 10 months, amid hopes of a sustained recovery in the economy.
In contrast, the yield on 10-year Treasury notes has made a circular journey, rising from about 3.50 per cent at the start of the month, peaking near 3.90 per cent in early-August, only to be trading about 3.42 per cent on Wednesday. “Something has to give when all you see are green arrows for prices across the major asset classes,” says George Goncalves, head of fixed-income strategy at Cantor Fitzgerald. “Strong commodities and stocks with falling bond yields cannot continue, at some point the normal relationships should resume.” The breakdown between equities and bond yields reveals how divided investors are over the sustainability of the economy’s recovery.
While some equity research touts a V-shaped recovery for the economy, bond investors believe the economy will only derive a short-term boost from the replenishment of inventories. Beyond a bounce in activity this year, the debt-laden consumer is in no position to pick up the baton and accelerate the recovery into 2010, many argue. “It may well be that more [bond] investors are signing on [to] the ‘sugar high’ from stimulus thesis and [are] worried about what crash lies beyond the boost from homebuyer tax credits, cash-for-clunkers and other temporary/transitory props for the US economy,” says Bill O’Donnell, strategist at RBS Securities.
The release yesterday of durable goods orders for July highlighted the dichotomy, with the headline number exceeding forecasts, while capital goods orders excluding defence and air orders fell 0.3 per cent, the first decline since April. Not even a deteriorating debt outlook by the White House and Congressional Budget Office, with the budget deficit seen rising a further $2,000bn over the next 10 years, has derailed the bond market’s rally. Recent auctions of new debt by the US Treasury have attracted solid demand from foreign central banks and investors, limiting concerns about the rising tide of new supply.
That comes amid deep misgivings in some quarters about the quality of the S&P’s rise of more than 50 per cent from its low in March. That rally represents the strongest rebound in stocks since the explosive short covering rallies of the 1930s when the market rose more than 100 per cent. Equity volume has been low, while the best performing stocks, such as AIG, Fannie Mae, Freddie Mac and Citi, have generally been those that were heavily shorted during the depths of the sell-off.
The rally in both Treasuries and stocks has caught some trading rates desks offguard and that has only boosted bond prices as dealers have reversed their lossmaking trades. But an even bigger trap could be brewing for investors banking on stocks following their usual September to October pattern of performing poorly. “As seasoned investors surely know, September has historically been the worst month for the market during the year,” say analysts at Bespoke Investment Group. This could explain why bond investors are driving yields lower.
“Everyone we speak with is keeping powder dry for the stock market weakening next month and during October and I think bond yields are falling ahead of that move,” says Tom di Galoma, head of Treasury trading at Guggenheim Partners. “One market is completely wrong and if equities don’t turn lower, then they could run quite considerably as money moves off the sidelines.” That could also spark a dramatic reversal in Treasury yields. However, expectations that inflation will continue falling makes bond yields look attractive, particularly when the 10-year note approaches 4 per cent.
“The economic data has been better, but we are not looking for the economy to experience explosive growth next year, while many global indicators point to disinflation,” says Bill Strazzullo, chief market strategist at Bell Curve Trading. He said weak labour hiring trends, falling real estate values and excess capacity in manufacturing would keep prices contained and boost the appeal of owning bonds. Then there is the performance of credit, which has generated huge returns for investors since the start of the year, with high-yield debt alone up 40 per cent. The lower end of Investment grade credit spreads have contracted more than two percentage points to 6.5 per cent since April, the lowest level since the start of 2008.
Credit has lagged behind the rise in equity prices and that has some analysts thinking that this helps explain why yields have fallen, while stocks have risen. “We have seen an asset allocation out of credit, because it’s had such a good run, and that money has gone into Treasuries,” said Gerald Lucas, senior investment advisor at Deutsche Bank. Another aspect of the financial crisis has been a narrowing of options for investors, with many investors preferring to place their money in liquid markets. The combination of rising risk tolerance and enormous amounts of liquidity supplied to the financial system by central banks, may explain why asset classes are rallying in unison.
“There is so much money in the system and it appears anything with a price is going up as people put cash to work,” says Mr Goncalves. “It’s perplexing to see different asset classes going higher in value.” It is indeed a trend that has plenty of people scratching their heads and warning it cannot last. “I would argue that if the recovery is sustainable then eventually rates at the short end will have to rise, and inflation expectations from the massive monetary stimulus will push rates higher in the longer maturities,” says John Prior, technical analyst at Killik Capital in London. “Unless we are going back to the Goldilocks economy of inflation-free growth, I don’t believe the current situation can continue indefinitely.”
FDIC: Number of troubled banks rises to 416
The Federal Deposit Insurance Corp. said Thursday that more lenders ran into financial trouble during the second quarter as the recession continued to saddle banks with soured loans. The FDIC said that the number of troubled banks rose to 416 at the end of June from 305 at the end of March. This is the largest number of banks on its "problem list" since June 30, 1994, when 434 banks were on the list.
Assets at troubled banks totaled $299.8 billion, the highest level since Dec. 31, 1993, the agency said Banks insured by the FDIC swung to a total quarterly loss of $3.7 billion from last year when they reported a total profit of $4.8 billion. Total reserves of the Deposit Insurance Fund stood at $42 billion, with the contingent loss reserve falling to $10.4 billion from $13 billion over the second quarter. Some analysts have been warning that growing bank failures could put pressure on the FDIC fund.
"While challenges remain, evidence is building that the U.S. economy is starting to grow again," said FDIC Chairman Sheila Bair in a press release. "The banking industry, too, can look forward to better times ahead," she added. "But, for now, the difficult and necessary process of recognizing loan losses and cleaning up balance sheets continues to be reflected in the industry's bottom line."
Bair said the FDIC has "ample resources" to protect depositors. "No insured depositor has ever lost a penny of insured deposits ... and no one ever will," she asserted. More than 28% of all insured institutions reported a net loss in the second quarter, compared with 18% in the year-ago quarter. "Deteriorating loan quality is having the greatest impact on industry earnings as insured institutions continue to set aside reserves to cover loan losses," Bair said.
Can the soufflé really rise again?
Two facts that should give pause for thought.
- Japanese data released on Thursday showed that exports fell yet again in July. They are down 39.5pc to the US, and 26.5pc to China. Japan is the world’s second biggest economy. It lives on exports. It is also a key part of the supply chain for the Chinese economy. How can this hard data be reconciled with the extreme V-shaped recovery already priced in by the markets? By the way, Toyota is suspending a key production line at its Takaoka plant in central Japan. It is cutting global capacity by 1m vehicles.
- The Baltic Dry Index measuring freight rates for bulk goods and commodities has been falling almost continuously for eleven weeks, dropping from 4,290 to 2,778 on Thursday.
Is this just a glut of ships or is this telling us what the Shanghai market is also telling us, that credit tightening by the Chinese government is pulling the rug from underneath the latest commodity bubble?
There is something wrong with the entire recovery tale, which ignores the fact that excess plant is still at the highest level since the Great Depression (capacity use is 70pc in Europe, 68pc in the US, 65pc in Japan, and as low as 50pc in some countries, according to the World Bank’s Justin Lin). Companies will have to cut jobs and investment. Soaring “confidence” indicators have decoupled from reality. The world economy is still prostrate. GDP has shrunk 4pc, 6pc, 8pc, even 12pc or more in a large group of countries. There it more or less sits, like a deflated soufflé.
An end to technical recession in France, Germany, and Japan because Q2 ( and undoubtedly Q3 to come) ekes out a rise from a collapsed base does not mean anything – except that zero interest rates worldwide, and a massive fiscal stimulus that is pushing public debts towards 100pc across the OECD states (and cannot easily be repeated once the first sugar rush subsides), has mercifully prevented the Great Contraction from turning into an immediate catastrophe. As the Bank of England’s Governor Mervyn King puts it: “It’s the level, stupid”. The level of economic activity is years away from full recovery.
The Bundesbank’s Axel Weber says it will take until 2013 for Germany to get back to where it was. He also warns, by the way, that there will be a second wave of the credit crisis as Germany’s home-grown troubles come to the fore. Round one was imported havoc from the US: round two will be rising defaults at home and a credit squeeze as ratings downgrades force banks to set aside fresh capital.
I have no idea when stock markets and commodities – especially base metals – will reflect the hard facts on the ground (ie, an end to the Chinese construction bubble). Timing is not my forte. Nor is the market. But I am absolutely convinced that those who think we can return to the status quo ante of the credit bubble as if nothing has happened are delusional. As almost every central banker in Jackson Hole reminded us over the weekend, it is going to be a very long hard slog.
Real US unemployment rate at 16%: Atlanta Fed President
The real US unemployment rate is 16 percent if persons who have dropped out of the labor pool and those working less than they would like are counted, a Federal Reserve official said Wednesday. "If one considers the people who would like a job but have stopped looking -- so-called discouraged workers -- and those who are working fewer hours than they want, the unemployment rate would move from the official 9.4 percent to 16 percent, said Atlanta Fed chief Dennis Lockhart.
He underscored that he was expressing his own views, which did "do not necessarily reflect those of my colleagues on the Federal Open Market Committee," the policy-setting body of the central bank. Lockhart pointed out in a speech to a chamber of commerce in Chattanooga, Tennessee that those two categories of people are not taken into account in the Labor Department's monthly report on the unemployment rate. The official July jobless rate was 9.4 percent.
Lockhart, who heads the Atlanta, Georgia, division of the Fed, is the first central bank official to acknowledge the depth of unemployment amid the worst US recession since the Great Depression. Lockhart said the US economy was improving but "still fragile," and the beginning stages of a sluggish recovery were underway. "My forecast for a slow recovery implies a protracted period of high unemployment," he said, adding that it would be difficult to stimulate jobs through additional public spending.
"Further fiscal stimulus has been mentioned, but the full effects of the first stimulus package are not yet clear, and the concern over adding to the federal deficit and the resulting national debt is warranted," he said. President Barack Obama's administration has resisted calls for more public spending, arguing that the 787-billion-dollar stimulus passed in February needs time to work its way through the economy.
Lockhart noted that construction and manufacturing had been particularly hard hit in the recession that began in December 2007 and predicted some jobs were gone for good. Prior to the recession, he said, construction and manufacturing combined accounted for slightly more than 15 percent of employment. But during the recession, their job losses made up more than 40 percent of all US job losses.
"In my view, it is unlikely that we will see a return of jobs lost in certain sectors, such as manufacturing," he said. "In a similar vein, the recession has been so deep in construction that a reallocation of workers is likely to happen -- even if not permanent." Payroll employment has fallen by 6.7 million since the recession began.
Second-Quarter GDP Is Unchanged, Jobless Claims Edge Lower
The government left untouched its estimate of the U.S. economy in the second quarter, saying inventory liquidation was deeper than first thought and consumer spending not as weak -- a positive sign for growth this summer. A separate report showed the number of U.S. workers filing new claims for jobless benefits declined last week, falling in line with economists' observations that labor market conditions appear to be slowly stabilizing. The total claims lasting more than one week also fell back down after ticking up the previous week.
The Commerce Department on Thursday released its second estimate of second-quarter GDP, saying again gross domestic product fell at a seasonally adjusted 1% annual rate April through June. The data was favorable for third-quarter economic activity. It said inventories were slashed $159.2 billion in the second quarter, revised from a previously reported $141.1 billion cut. More liquidation in the second quarter suggests a lower need to cut so deeply in the third quarter, which would help economic growth.
The recession began in December 2007, according to the arbiter of such things, the National Bureau of Economic Research in Cambridge, Mass. The non-profit research group uses a broader definition of a recession than do many economists. The traditional definition of a recession is two consecutive quarters of a shrinking GDP. The current, third quarter began July 1. Economists expect a rise in GDP this summer, suggesting the recession is at or near its end.
GDP acts as a scoreboard for the economy by measuring all goods and services produced. It fell 6.4% in the first quarter and 5.4% in the fourth quarter. Wall Street expected a big change to second-quarter GDP. Economists surveyed by Dow Jones Newswires projected the revised data would show GDP fell 1.5%, instead of the 1.0% drop reported a month ago. Gauges on inflation were generally unrevised. Corporate profits rose 7.5% in the second quarter, after rising 16.6% during the first quarter.
Real final sales of domestic product, which is GDP less the change in private inventories, increased at a 0.4% annual rate in the second quarter, revised from a previously estimated 0.2% dip. Business spending fell 10.9%, revised from an 8.9% drop reported earlier. Most of GDP is made up of consumer spending. It slid by 1.0% April through June, revised from a previously reported 1.2% drop. U.S. exports fell by 5.0% and imports decreased an unrevised 15.1%. The original GDP report for the second quarter said exports fell 7.0%.
Residential fixed investment, which includes spending on housing, dropped by 22.8%, revised from a 29.3% plunge first reported. Federal government spending increased 11.0%, revised from a previously estimated 10.9% increase. The government's price index for personal consumption expenditures climbed an unrevised 1.3% in the second quarter. The PCE price gauge excluding food and energy rose an unrevised 2.0%. The price index for gross domestic purchases, which measures prices paid by U.S. residents, rose 0.5%, revised from a previously reported 0.7% climb. The chain-weighted GDP price index was flat; originally, Commerce reported a 0.2% climb.
Initial claims for jobless benefits fell 10,000 to 570,000 in the week ended Aug. 22, the lowest level since Aug. 8, the Labor Department said in its weekly report Thursday. Economists surveyed by Dow Jones Newswires had expected a decline of 11,000. The previous week's level was revised from 576,000 to 580,000. The four-week average of new claims, which aims to smooth volatility in the data, fell 4,750 to 566,250. That was the lowest average since the week ended Aug. 8. The latest drop in the weekly initial claims data follows two straight weeks of disappointing increases. For the week ending Aug. 15, claims had unexpectedly climbed, raising concerns that improvements in the labor market are still are not likely to be seen in the near-future.
Despite those recent setbacks, economists have tended to react a bit more positively to the weekly jobless claim figures because they are still seeing an overall downward trend in claims. Abiel Reinhart, an economist at J.P. Morgan Chase & Co., said in an interview with Dow Jones that he felt some people last Thursday over-reacted a little bit to the news that claims had risen by 15,000 in the week ended Aug. 15. "If you were to chart what has happened here over the last couple years , it still to me looks to be on a downward trend and I think it's a matter of just having a little patience," he said. In Thursday's report, the number of continuing claims -- those drawn by workers for more than one week in the week ended Aug. 15 -- fell 119,000 to 6,133,000. That followed a rise of 2,000 the previous week.
A Plunge in Foreign Net Capital Inflows Preceded the Break in US Financial Markets
The peak of foreign capital inflows into the US was clearly seen in the second quarter of 2007, just before the crisis in the US that has rocked its banking system and driven it deeply into recession.
Are the two events connected? Had the US become a Ponzi scheme that began to collapse when new investment began to wane, and the growth of returns could not be maintained?
Watch the dollar and the Treasury and Agency Debt auctions for any further signs of capital flight, which is when those net inflows of foreign capital turn negative. And if for some reason the unlikely happens and it gains momentum, the dollar and bonds and stocks can all go lower in unison, and there is no place to hide except perhaps in some foreign currencies and precious metals.
The sad truth is that US collateralized debt packages and their derivatives have become toxic in the minds of the rest of the world, and there is little being done to change that, except an orderly winding down of the bubble, with the remaining assets being divided largely by insiders, and not price discovery and capital allocation mechanisms driven by 'the invisible hand' of the markets.
Unfortunately the Net Inflow Data is quarterly, and subject to revisions. But we have to note that the spectacularly rally off the bottom in the SP 500, not fully depicted above, is not being matched by a return of foreign capital inflows.
If that inflow does not return, if the median wage of Americans does not increase, if the financial system is not reformed, if the economy is not brought back into balance between the service and manufacturing sectors, exports and imports, then there can be no sustained recovery in the real, productive economy.
The rally in the US markets is based on an extreme series of New Deal for Wall Street programs from the Fed and the Treasury, monetization, and the devaluation of the dollar.
The Political Phase and the Death of Nations
by Bill Bonner
The United States is in the third and fatal stage of a great country’s lifecycle — the political stage. In this stage, money and power migrate from the financial community to the political community. The politicians get away with taking trillions out of the productive economy and spending them on their pet projects and private corruptions. “Politics is about what works,” someone once said. Someone said it…someone who is an imbecile. Politics is not about what works, it’s about what you can get away with. And what you can get away with is often exactly what doesn’t work at all.
What the United States is getting away with, from a financial point of view, in addition to counterfeiting, is grand larceny on a Super-Madoff scale. It is borrowing trillions of dollars even though it has no way to honestly pay back the money. Still, so eager are the lenders to part with their money that the 10-year T-note yields a miserly 3.46%. The more the feds borrow, apparently, the more lenders are willing to lend. But this is a story that will end badly.
Warren Buffett described the America of the bubble years as “Squanderville.” Private citizens were living beyond their means, he pointed out. But he hadn’t seen nothin’. Now, government does the squandering. The politicians are spending trillions they don’t have on projects nobody was willing to pay for even when they had some money in their pockets. What the government can get away with now — under cover of a financial crisis — is a big grab for money and power. It ‘works’ in the sense the feds are able to get away with it. But it will prove fatal to the dollar…and to the US economy.
The Fed is intervening in markets as no Fed ever has. Its balance sheet — a measure of how much intervention it has done — has shot up in a way that is not only unprecedented, but also almost unbelievable. In an effort to provide liquidity, the Fed has bought up the contents of every neglected refrigerator on Wall Street. This smelly, furry stuff enters the Fed’s books as an asset, along with various not-so-pungent assets like US Treasury bonds. Altogether, the Fed’s balance sheet shows more than $2.7 trillion worth of this unappetizing hodgepodge.
“It’s not sound economics — nor is it ethical — to trash the US dollar and bail out incompetent investors who poured billions into CMBS at the peak of the bubble,” says Strategic Short Report’s Dan Amoss. “There is no longer a ‘systemic risk’ argument for The Fed to be propping up the price of such securities.
What happens next? We don’t know. But it is far too early to expect the Fed to withdraw its easy-money policy. The Fed will have to stay on this road for much, much longer. Why? Because the “green shoots” are shriveling up. There is no real economic revival. And there can’t be one until the underlying problems are corrected.
One of the big problems is too much capacity. During the Bubble Epoque the squanderers would buy anything. So, you could make an almost unlimited amount of money by providing them with things to buy. This meant building factories…buying trucks…and renting retail space. Now, however, the squanderers have come to their senses…or maybe they’ve just come to the limit of their credit lines. The squanderers now want to save their money. So, no need for so much retail space in the malls, so many trucks on the highways or so much retail space.
There are a number of sit-down restaurant chains that cater to the middle class — Applebee’s…Chili’s…Ruby Tuesday and a few others. They expanded greatly during the ’90s and ’00s in order to meet the desires of the big-spending masses. But now that the masses aren’t so free and easy with their money, the New York Times reports that these chains are in desperate competition for remaining diners. This competition is manifesting itself as price deflation.
Applebee’s offers dinner for two for only $20. Chili’s advertises entrees for just $7. Ruby Tuesday’s is going for a 2-for-1 deal. Buy one meal, get one free. All of them are making heavy use of discount coupons. Oversupply is producing deflation. Prices are falling as suppliers fight for demand by offering more for less. And over at the Red Roof…the roof has already caved in, as the chain has defaulted on its mortgage debt.
This is what you’d expect at the end of a long period of credit expansion. EZ credit brought forth too much demand and too much supply. Now, the demand is disappearing…and the suppliers struggle to hold on. Even now, we’re facing an economy in which 70% of our economic output depends on consumer buying. And consumers are in no condition to consume. Ergo, no buyers, no recovery.
Economic contraction is natural, normal and perhaps necessary to a market economy. And the current contraction will take years to sort out. Roofs have to fall in on thousands of enterprises, speculators and households. Then, the rebuilding can begin. But the Bernanke Fed is not about to let nature take her course. Don’t expect any tightening from the Fed anytime soon, dear reader…it is far too soon for that.
Governments are essentially parasites on productive activity. So the best governments are the smallest — meaning, the least parasitic. As has been said before, “That government is best which governs least.”
But now we are in the third and fatal stage of a great country — the political stage. In this stage, the parasites take over. Government governs a lot. And governing a lot costs a lot of money. In England, the government budget is bumping up against half the total GDP of the nation. In America, health care is still largely a private matter, so the government spends a smaller percentage of GDP…but it is a percentage that is rising quickly.
Where will the money come from? Taxes? Gordon Brown has already put the income tax rate up to 50%. Michael Caine, an English actor who moved from the U.S. to England to escape the high taxes of the ’70s, says he will tolerate 50%…but not a penny more.
“If it goes to 51% I will be back in America,” he says.
Ahem…he might have to try somewhere else. Everybody’s gunning for the rich — in America as well as in England. Obama has pledged to raise taxes on the rich. The states, notably California, are desperate for more revenue too. Add federal, state and local levies…and private health care costs…and you could easily be over the 50% bracket in America too.
The history of European monarchies is largely a history of debt. Kings and queens squeezed what they could out of the turnips. Then they turned to the moneylenders. These lenders had to be careful. They were happy to extend monarchs credit, because in this way they gained a measure of control over them. But there were many dangers. Kings lost their heads…or went broke. Or, often, the monarchs could turn the tables on the moneylenders…and have their heads cut off. Reading the history of the loans to the French crown is eye-opening. It is amazing anyone wanted to lend at all. The risks were great; the rewards were few. Rarely were the loans settled honorably.
Government raises money. Sometimes it repays the loan with revenues from other taxes. Sometimes, it is the lender who pays the tax himself — either because the government defaults…or because inflation reduces the value of his money. What you come to see is that lending to the government — which always has the power to betray the loan and behead the lender — is merely another form of taxation. But the lender can blame no one but himself for his losses. The wounds he suffers are self-inflicted.
This is a story that often ends badly, if not disastrously.
Economic Crisis Strikes at Irish Heartland
A key gauge of Ireland's economic health isn't found in the island nation's business districts or trading floors, but on the football fields of the rural west, where rosters of amateur clubs are getting so thin that villages are struggling to find talented players to field 15-person teams. Sean McManamon left Ballycroy -- a picturesque village sandwiched between the Atlantic Ocean and the Nephin Beg mountain range -- for a job in London in February after his small construction firm folded. Mr. McManamon, a midfielder who was a stalwart of the Ballycroy team's defense, emigrated around the same time as three other players, leaving the village without an adult team for the first time in more than 50 years.
It is the 35-year-old father of four's second stint as an emigrant. He hopes it is his last. Emigrating again, after being in London for eight years and returning in 1999 to capitalize on Ireland's real-estate boom "was easily one of the hardest things I've ever done," says Mr. McManamon, who left his family, a 100-acre farm and a nearly finished seven-bedroom home behind. "I never thought I'd leave Ireland again."
Even as the economic crisis crimps migration world-wide, there are signs that Ireland's particularly dire straits -- unemployment hit a 14-year high of 12.2% in July and the central bank expects the economy to shrink by 8.3% this year -- are pushing increasing numbers of workers abroad. Official emigration statistics will be released later this year; some economists believe Ireland could see outflows of up to 40,000 people a year, the equivalent of nearly 2% of the country's labor force, for the next few years.
The U.S. Embassy in Dublin says Irish applications for short-term work visas are up in the last year. Irish emigrant centers across the U.S. report more new arrivals. Mark O'Donnell, director of human capital at Deloitte in Dublin, says 10% of the 2,000 Irish executives who are potential job candidates for his corporate clients are now working overseas, up from "pretty much zero" last year.
Most tellingly for many here, Ireland's most popular sports -- traditional amateur games called Gaelic football, which resembles a mix of soccer and rugby, and hurling, a sport similar to field hockey and lacrosse -- are seeing domestic teams struggle as players head overseas in search of work. The Gaelic Athletic Association that oversees the teams was founded in 1884 to preserve Irish traditions amid rampant poverty and emigration. Now, Ireland boasts more than 2,500 GAA clubs; increasingly popular overseas teams cater to the country's vast diaspora.
But teams here in Ireland, especially those along the sparsely populated rural west coast, are suffering as players leave. "You can tell what's happening in a local Irish community by what's happening with the GAA club," says Mark Duncan, director of the GAA Oral History Project at the Dublin campus of Boston College. It's a trope of Irish history, he says, that "if a village is struggling to field a team, something is wrong. There's a sense of despair and crisis about the place, that you can't hold on to your young people."
The Irish have a long and painful history of leaving. Starvation and emigration amid the mid-19th century potato famine cut Ireland's population by nearly a third, to 4.4 million in 1861. Emigration continued after Ireland won independence from Britain in 1921; more people left the country than came to it every decade until a 1970s economic revival stemmed the tide. But double-digit unemployment pushed people abroad again in the 1980s.
"For people who grew up here before the 1990s, emigration was a part of the national psyche," says Alan Barrett, an economist with Dublin's Economic and Social Research Institute. That changed when the economy took off in the mid-1990s, he says. "Some would argue that the greatest benefit of the Celtic Tiger was the notion that if you were born in Ireland you had a reasonable prospect of staying." That notion is fading. Ballycroy native David Doran, 24, worked in Ireland's construction industry for six years until work dried up in January. So Mr. Doran moved to London, where older brothers who emigrated years ago helped him find work. "There's nothing here now," he says, sipping a Guinness in one of Ballycroy's two pubs while home on a recent visit.
The current outflow remains meager compared with Ireland's past emigration waves. Unemployment rates are rising world-wide and some would-be Irish emigrants are returning home empty-handed. Many of those leaving Ireland now are also immigrants themselves. In 1996, 8,000 more people came to Ireland than left it, the start of more than a decade of inflows that turned the onetime emigrant nation into an immigrant hub. But foreigners are returning home amid the slump.
And though Ireland is set for a steep decline, few believe it will see a repeat of the lost decade of the 1980s. The government has unveiled painful spending cuts to bring down the budget deficit -- forecast to hit 10.75% of GDP this year. Emigration could even help in the short term, by keeping a lid on unemployment and whittling the government's social-welfare payments. Years of strong growth also yielded a psychological boost that could lure emigrants home once recovery takes hold. "One of the benefits of the boom was that it proved Ireland is a viable economic entity," says the ESRI's Mr. Barrett. "So there's a confidence that growth can be restored and that it's possible to sustain on this island a population in excess of 4.5 million people."
But the departures are hurting Irish towns and teams, especially along the western coast, where poor infrastructure and a lack of industry have long pushed workers away. Last year, Ballycroy -- where the population has shrunk by more than half since 1941 to just under 700 -- completed work on a new Gaelic football field.
On a recent Friday, the grass was calf-high and the changing rooms were strewn with trash. When Sean McManamon and other players emigrated to London this year, the town's chances of fielding a full team evaporated. "We were small -- we were a junior team and we played in the lower divisions," says Eoin Sweeney, 31, a physical therapist whose family owns Ballycroy's general store. "But it's the tradition of the thing. This is the first time I haven't played football in Ballycroy since I'm about 8. It hurts."
Teams from bigger communities are also taking a hit. Some 35 miles east of Ballycroy, the streets of the 10,000-person town of Ballina are dotted with empty storefronts and "To Let" signs. Ballina's Gaelic football team won the national championships in 2005. But the team has seen eight key players leave since 2008 and lost its semifinal match by two points earlier this month. "We suffer with emigration anytime there's a recession," says club treasurer Mickey Tighe, 42, who has been with the team as a player or manager for 25 years. "But this is the worst I've ever seen."
Ireland's new emigrants do benefit from perks that their predecessors lacked. Technology keeps them in steady contact with loved ones back home, while cheap and frequent flights make visiting easier. A round-trip flight from London to west Ireland can cost Sean McManamon as little as 40 pounds ($66), a price that lets him come home monthly. But it doesn't erase the pain of being away. "All the money in the world doesn't pay for not being home with your family in the evening," he says.
German state may lend directly as second credit crunch looms
Germany could directly intervene in the credit insurance and lending markets as soon as September to head off a looming credit crunch, as it fears the economic recovery may soon falter as banks refuse to roll over loans. The finance minister, Peer Steinbrück, said broad sectors of the German economy are in trouble even if the country has avoided a full-blown lending crisis so far. "Conditions have become much tougher for some industries – electrical engineering, machine tools, suppliers, chemicals and shipbuilding. We have clear evidence from both small and large companies that lending is jammed.
"The banks are not stepping up to their responsibility to provide credit," he told the German paper Handelsblatt. "Some indicators that have performed better, but... it is too early to say we have shaken off this crisis. There is still lots of risk and uncertainty, and no grounds for complacency. The fact that GDP proved better in the second quarter with 0.3pc growth is somewhat reassuring, but let's not forget the economy has shrunk 7pc from a year before."
Mr Steinbrück has now backed away from talk of forcing banks to lend, recognising they have to rebuild their capital, and shifted the focus to direct lending by the state. Among likely measures are use of the state-bank KFW to make "global loans" to industry on terms that pass on the full benefit of lower interest rates, as well state aid for credit insurance and trade finance. He said the bank rescue fund SoFFin still had €60bn left for support. While some measures have been discussed before, there appears to be a new urgency. Decisions may be made by "early September".
The comments are hard to reconcile with the a record surge in the IFO business confidence index, which jumped for a fifth month to 90.5 in August. Sentiment is racing ahead of economic hard data. Axel Weber, the Bundesbank chief and until recently the arch-hawk, last week spoke of a second wave of the credit crisis as home-grown problems come to light, triggered by ratings downgrades that force banks to put aside more capital. "The first round of disruption in the bank balance sheets from structured credit products is behind us. Now we are threatened by stress from our domestic credit industry," he said.
"They are in panic," said Hans Redeker, currency chief at BNP Paribas. "They know the money supply and credit figures coming out are going to be awful." He added that Germany's stimulus measures have put off deep problems until after the election in September. The car scrappage scheme has brought forward demand, implying a cliff-edge drop when the scheme expires. Kurzarbeit (short work) schemes that subsidise companies to keep idle workers on their books are slowly bleeding corporate balance sheets. "This has delayed the restructuring that needs to occur," he said.
Mr Steinbrück said markets are awash with liquidity again, but little is going into the real economy. "The banks evidently prefer to put their money into securities rather then granting new loans because they can get a higher return. After two years of financial crisis the gambler mentality is gaining the upper hand again." The German authorities are deeply frustrated that so few banks have resorted to the rescue scheme to rebuild their capital base. Critics say the Bundestag imposed such stringent conditions that lenders have opted instead to rein in lending. Mr Steinbrück said state lenders pose a "systemic risk" to German finance. Few of the regional banks have a "viable" business model.
Japan Economic Reports May Deal Blow to Aso on Eve of Election
Japanese economic reports are likely to deliver more bad news to Prime Minister Taro Aso tomorrow, two days before a general election that may oust his ruling Liberal Democratic Party for the second time in 54 years. The unemployment rate rose last month, matching a record high of 5.5 percent, and consumer prices excluding fresh food dropped an unprecedented 2.2 percent, deepening Japan’s deflation, economists expect the government figures will show.
The LDP trails the Democratic Party of Japan in polls ahead of the Aug. 30 lower-house election amid voter discontent over the government’s management of an economy that’s emerging from its worst postwar recession. Tomorrow’s figures will help the opposition cement its lead, said economist Kyohei Morita. “The deflation and historic deterioration in the job market will be widely reported,” said Morita, chief economist at Barclays Capital in Tokyo. “That’s something politicians really don’t need right before the election.”
The DPJ may win more than 300 seats out of 480, according to a poll by Kyodo News released this week. The opposition already controls the less-powerful upper house. Finance Minister Kaoru Yosano said on Aug. 25 that the party is “engulfing Tokyo like a massive wave.” The labor and inflation reports “won’t influence the election outcome,” Economic and Fiscal Policy Minister Yoshimasa Hayashi said this week. “We will keep explaining the details of our policies to voters as much as possible until the last minute,” said Hayashi, who is an upper-house LDP lawmaker.
The jobless rate was at a six-year high of 5.4 percent in June, close to a record 5.5 percent last seen in April 2003. Unemployment was also rising in 1993, when the LDP lost power for the only time in its history to a coalition led by Morihiro Hosokawa. The rate was at a five-year high of 2.5 percent when the election was held in July of that year as the economy ground to a halt after an asset bubble burst. The ruling party says it will continue a policy of financially supporting employers who place workers on leave instead of firing them. The Aso administration has also made more people eligible for unemployment insurance.
The DPJ, which has never governed, promises to raise the minimum wage and discourage hiring through agencies or on temporary contracts. Temporary workers, who have borne the brunt of the layoffs during the recession, should get equal pay and as much access to training as their permanent counterparts, according to the party’s election campaign pledge. After a collapse in exports and production in the first quarter of this year, the number of non-regular workers fell 470,000 from April to June, the biggest drop since the survey began in 2003, the statistics bureau reported this month.
Graduates are also suffering. Moto Yokota, 21, is one of the 447,000 students who hope to find a job before graduating in March. After being rejected by 30 companies, the senior bioscience engineering student said the setbacks prompted him to stop job hunting for a month in July. “Whoever wins the election, it won’t change this horrendous job environment,” Yokota said. “It’s depressing because I’m doing my best but I have no clue about when I can get out of this.” The number of jobless in the world’s second-largest economy has swelled by 1 million people since the recession began in November 2007 to 3.6 million in June.
A collapse in demand at home and abroad has left businesses with excess workers. The unemployment rate would have been 12.2 percent in June had all of Japan’s surplus labor been considered unemployed, according to Takahide Kiuchi, chief economist at Nomura Securities Co. in Tokyo.
Toyota Motor Corp., Japan’s biggest automaker, said yesterday that it will shut down a domestic assembly line as sales plunge. Japan Airlines Corp. may cut 5,000 jobs, or about 10 percent of its workforce, in three years, Kyodo News reported this week. Sanyo Electric Co. said yesterday it will offer early retirement as it scales back some businesses. Hisako Abe, 53, has been looking for a job since she was fired in April after working for a textile manufacturer for eight and a half years. “I don’t think it’s going to make a difference whether the LDP or the DPJ end up governing,” Abe said at an unemployment office in Tokyo last week. “Either way, the economy won’t get better anytime soon.”
Big Deficits Could Hurt Obama on Health Care & Energy
If anyone was surprised that President Obama took time away from his summer vacation to announce that he’ll keep Ben Bernanke on as chairman of the Federal Reserve Board, the benefit of that scheduling became clear a few hours later. Bernanke’s reappointment drew at much of the attention away from the horrendous news on the deficit front.
The day’s headlines and cable chatter, as well as the reaction in the markets, focused far more on the President’s 9:00 appearance in Martha’s Vineyard with Bernanke than on the release by the White House, just 30 minutes later, of revised budget estimates projecting that the cumulative deficit over the next ten years could hit an $9 trillion, nearly $2 trillion more than the Administration had estimated in May.
The reassurance that Helicopter Ben would remain at the helm — combined with the fact that the deteriorating budget numbers had been strategically leaked the previous Friday — helped turn the rapidly rising deficit largely a non-event for the markets: indeed, by days’ end, the yield on 10-year Treasuries had even dropped slightly, to 3.44%. “It’s a Bernanke rally,” says Greg Valliere, who covers Washington policy for institutional broker Soleil Securities. “The deficit numbers are too abstract for most people to grasp; with yields this low, it’s hard for people to say (the deficit) will damage the recovery.”
But Washington is unlikely to be quite so accomodating in overlooking those skyrocketing deficits when the President and his advisors return from vacation for the next stage of the battle over priorities like health care reform or the potentially costly cap-and-trade bill aimed at lowering the harmful emissions that lead to global warming. "The more you see these big numbers coming in, the harder it becomes to push forward an agenda that involves big costs," says Daniel Clifton, the Washington-based analyst for institutional broker Strategas Research Partners.
Already, Republicans opposed to the estimated $1 trillion dollar price tag for the health care bills that emerged from the House before the August recess are calling for the plans to be trimmed back. House GOP leader John Boehner argues that the country's already severe budget problems will only get worse if the current plans move forward. "Instead of putting the brakes on Washington's spending habits as they promised they'd do, Democrats have stepped on the accelerator and spent taxpayer dollars with reckless abandon all year," he said in a statement.
Meanwhile, fiscally conservative Blue Dog Democrats, after getting an earful at home from constituents worried about runaway spending in Washington, have also rebelled against plans that appear far more focused on expanding health care coverage than on holding down costs. Many of them, fearful of losing seats in states that traditionally vote Republican, could play a critical role in forcing Obama to back down on spending plans this fall.
"You will have a bunch of House Democrats elected from fiscally conservative districts, who will need to show (voters) something to get themselves (elected) back into Congress," says Stan Collender, the managing director of Washington-based communications firm Qorvis Communications who writes frequently on the budget. "They could make it impossible for the President to do anything else if the Administration doesn’t start deficit reductions."
That's likely to hit first, and hardest, on health care. Sen. Chuck Grassley, the ranking Republican on the Senate Finance Committee and a key negotiator in attempts to develop a bipartisan health care bill, has called for spending on reforms to be cut back to below $800 billion. Collender also predicts the deficit numbers will embolden those who would like to see the health care measures defeated altogether: "Those who don't want to see reforms will say (the numbers) should stop it in its tracks," he says. Pressures will also rise on the Administration to come up with more specific, targeted cuts to hold down the growth in health care spending; for now, few analysts put much stock in the Administration's vague committment to "bending the curve" on costs.
"Their rhetoric is spot on, they say all right things," says Maya MacGuineas, the head of the Committee for a Responsible Federal Budget and director of the fiscal policy program at the New America Foundation. But the Administration isn't making any of the hard choices on costs or putting forward concrete plans to show exactly what it would do to bring them down. While agreeing with Collender that the rising deficit will give those who oppose reform another weapon, she also argues that the deficit numbers may force much needed attention to that side of the debate. "It could give a much needed boost to those who argue that more has to be done about controlling costs," she says. "It could help get a tougher bill, one that truly slows growth."
Health care isn't the only policy area that could be impacted: the rising deficit could also put a crimp on other plans that would require big spending. Whatever limited enthusiasm existed around Washington for a second stimulus program is even lower today; despite still high unemployment, the chances that such a bill could pass have virtually disappeared unless the economy takes a far more serious double dip back into recession than most now project. Obama's ambitous cap-and-trade plans, already in deep trouble, could be further damaged by the perception that implementing the plan and any subsidies it might require could prove costly as well.
With little money in Uncle Sam's till to pay for his ambitous goals, Obama faces his toughest test yet when he returns from his Cape Cod vacation. "The agenda will be much more dominated by small incremental stuff going forward," says Clifton. Just six months into his term, the President, like many before him, could find his ability to move ahead with big plans increasingly constrained.
Market Has Likely Topped
by Doug Kass
Back in early March, there were signs of a second derivative U.S. economic recovery, the PMI in China had recorded two consecutive months of advances, domestic retail sales had stabilized, housing affordability was hitting multi-decade highs (with the cost of home ownership vs. renting returning back to 2000 levels), valuations were stretched to the downside and sentiment was negative to the extreme. These factors were ignored, however, and the S&P 500 sank to below 700.
To most investors, back in early March, the fear of being out was eclipsed by the fear of being in. Despite the developing less worse factors listed above, bulls were scarce to nonexistent in the face of persistent erosion in equity and credit prices.
It was at this point in time, on RealMoney Silver, in an appearance on CNBC's "Fast Money," on "Mad Money" and in multiple appearances on "The Kudlow Report," I confidently forecast the likelihood that a generational low had been reached.
I went on to audaciously predict that the S&P would rise to 1,050, a gain of nearly 400 points from the S&P low of 666 during the first week of March, by late summer/early fall. I even sketched a precision-like SPDRs (SPY Quote) expectation chart that would reach approximately the 105 level (a 1,050 S&P equivalent) within about six months.
Yesterday the SPDRs peaked at 104.20, within spitting range of my intrepid March forecast of 105, and the S&P nearly touched 1040 in Tuesday's early morning trading.
Arguably, today investors face the polar opposite of conditions that existed only a few months ago, with economic optimism, improving valuations and positive sentiment.
To most investors, today the fear of being in has now been eclipsed by the fear of being out as the animal spirits are in full force. Bears are now scarce to nonexistent in the face of steady price gains in equity and credit prices.
As if the movie is now being shown in reverse, the bull is persistent, stock corrections are remarkably shallow, cash reserves at mutual funds have been depleted, and hedge funds hold their highest net long positions in many moons.
Stated simply, in the current bull market in complacency, optimism and a boisterous enthusiasm reigns.
As I have written on these pages, the investment debate has morphed in a dramatic fashion from concerns as to whether U.S. economy was entering The Great Depression II to whether the current domestic recovery will be self-sustaining.
The primary question to be asked is, Will the earnings cycle dominate the investment landscape and cause investors to overlook the chronic and secular challenges facing the world's economies, particularly as the public sector stimulus is eventually withdrawn and paid for and the economic consequences of the massive public sector intervention manifest themselves in the form of higher interest rates and marginal tax rates?
Most now have accepted the notion that due to the replenishment of historically low inventories, extraordinary fiscal/monetary stimulation and the productivity gains from draconian corporate cost-cutting, the earnings cycle is so strong that it will trump the consequences of policy. More accurately, most believe that they can get out of the market before the full effects of policy are felt.
I am less confident as a decade of hocus-pocus borrowing and lending and 35-to-1 leverage at almost every level in both private and public sectors cannot likely be relieved in the great debt unwind over the course of only12 months.
It is important to emphasize that when I made my variant March call, I expected many of the conditions that now exist -- namely, a resurgence of economic and investment optimism during the summer to be followed by a multiyear period of weak investment returns. Specifically, I expected a mini production boom and an asset allocation away from bonds and into stocks to be embraced and heralded by investors, who would only be disappointed again in the fall as it becomes clear that a self-sustaining economic recovery is unlikely to develop.
My view remains that it is different this time. Again (now for emphasis), the typical self-sustaining economic recovery of the past will not be repeated in the immediate future for 10 important reasons that will weigh on the economy and markets like the governor that controlled the speed of the Good Humor truck I drove when I was in my teens during the summer:
- Cost cuts are a corporate lifeline and so is fiscal stimulus, but both have a defined and limited life.
- Cost cuts (exacerbated by wage deflation) pose an enduring threat to the consumer, which is still the most significant contributor to domestic growth.
- The consumer entered the current downcycle exposed and levered to the hilt, and net worths have been damaged and will need to be repaired through higher savings and lower consumption.
- The credit aftershock will continue to haunt the economy.
- The effect of the Fed's monetarist experiment and its impact on investing and spending still remain uncertain.
- While the housing market has stabilized, its recovery will be muted, and there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.
- Commercial real estate has only begun to enter a cyclical downturn.
- While the public works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye as most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.
- Municipalities have historically provided economic stability -- no more.
- Federal, state and local taxes will be rising as the deficit must eventually be funded, and high-tax health and energy bills also loom.
Just as I looked over the valley in March 2009 toward the positive effects of massive monetary/fiscal stimulation within the framework of a downside overshoot in valuations and remarkably negative sentiment, I now suggest another contrarian view is appropriate as I look over the visible green shoots of recovery toward a hostile assault of nonconventional factors that few business/credit cycles and even fewer investors have ever witnessed.
Yesterday, the OMB/CBO provided an exclamation point to the secular challenges that the domestic economy faces in forecasting an accumulated deficit of $9 trillion over the next decade (up $2 trillion from the previous forecast just two months ago), and public debt as a percentage of GDP is projected at an alarming 68% by 2019 (as compared to 54% today and only 33% in 2001). Thus far, the drop in the U.S. dollar (influenced, in part, by the mushrooming deficit) has been viewed favorably by the markets, but we must now be alert to a downside probe that becomes a threatening market factor. In other words, what has been viewed positively could shortly become negatively viewed.
A double-dip outcome in 2010 represents my baseline expectation. When the stimulus provided by the public sector is finally abandoned, it seems unlikely to be replaced by meaningful strength or participation by any specific component of the private sector, and the burgeoning deficit (described above) will ultimately require a reversal of policy, leading to higher interest rates, rising marginal tax rates and a lower U.S. dollar. My forecast assumes that the market's focus will shortly shift from the productivity gains that have been yielding better-than-expected bottom-line results toward these chronic and secular worries.
Even more important, my forecast of a 2010 market peak reflects that the aforementioned nontraditional influences (and the untoward policy ramifications) will, at the very least, yield a broad set of uncertain economic outcomes that (in consequence and in probability) tilt away from a self-sustaining economic scenario sometime in the following 12 months.
Stocks bottom during times of fear. With the benefit of hindsight, the March 2009 lows represented a dramatic overshoot to the downside.
Markets top during times of enthusiasm. I believe that the markets are now overshooting to the upside and that the U.S. stock market has likely peaked for the year.
Geithner: U.S. Fed needs shielding from politics
U.S. Treasury Secretary Timothy Geithner said on Wednesday the Federal Reserve should further increase its transparency, but its monetary policy activities need to be shielded from political influence. Geithner, answering questions voted on and posed by the Digg.com online community, did not endorse proposed legislation that would enable the Government Accountability Office to audit the Federal Reserve.
The question with the most votes from Digg, a social news website where users comment on submitted links and stories, was, "Why has the Federal Reserve bank never been audited?"
"You want to keep politics out of monetary policy," Geithner said, adding the Fed already has strong congressional oversight. "The Fed is dramatically more transparent than it was, is subject to very comprehensive oversight and audits, but there are certain things about what the Fed does that again you need to make sure you preserve as independent of political influence, that is free of political influence, and that is a line that we don't want to cross," Geithner said.
The third most popular question, which was posed to Geithner in a video interview administered by a Wall Street Journal editor, was whether Geithner supported Rep. Ron Paul's bill to conduct a comprehensive audit of the Fed. "Even the sponsor of that bill recognizes how important it is to us to have the Fed independent of politics," Geithner said. "And I'm sure that many people concerned about the Fed's role in the system will understand it would be problematic for the country if you let politicians come in and shape the conduct of monetary policy in the country."
The Fed has come under a sharp criticism from many lawmakers for actions taken under Chairman Ben Bernanke to pump trillions of dollars into the banking system and bail out failing institutions, all without funds appropriated by Congress. The debate over the Fed's actions and future role is sure to intensify as a confirmation vote for Bernanke's second term draws near. He was renominated this week by President Barack Obama in a move widely viewed as aiming for market stability during a fragile economic recovery period.
Many lawmakers and bureaucrats are also concerned about the Obama administration's plans to give the Fed sweeping new powers over large financial institutions whose failure could threaten the economy. Paul, a Texas Republican, has mounted a grass-roots campaign to get his audit bill considered for a vote in the Democrat-controlled Congress and claims 282 co-sponsors.
Geithner, asked whether he believed the Fed should become more transparent, said he did, and added that Bernanke had already done a lot to "open up the inner workings" of the U.S. central bank. But he noted that financial markets were a key judge of the Fed's policy performance. "Every day, every hour people can judge for themselves whether the Fed is doing what it's supposed to do under the laws of the land."
Atlanta Federal Reserve President Dennis Lockhart also said on Wednesday that audits of Fed monetary decisions was a bad precedent. "Even with absolutely good intentions, to have monetary policy audited after the fact, inevitably politicizes it, and I don't think that is in the interests of the country," Lockhart said after a speech in Chattanooga, Tennessee.
Federal Reserve Says Disclosing Emergency Loans Will Hurt Banks
The Federal Reserve argued yesterday that identifying the financial institutions that benefited from its emergency loans would harm the companies and render the central bank’s planned appeal of a court ruling moot. The Fed’s board of governors asked Manhattan Chief U.S. District Judge Loretta Preska to delay enforcement of her Aug. 24 decision that the identities of borrowers in 11 lending programs must be made public by Aug. 31. The central bank wants Preska to stay her order until the U.S. Court of Appeals in New York can hear the case.
“The immediate release of these documents will destroy the board’s claims of exemption and right of appellate review,” the motion said. “The institutions whose names and information would be disclosed will also suffer irreparable harm.” The Fed’s “ability to effectively manage the current, and any future, financial crisis” would be impaired, according to the motion. It said “significant harms” could befall the U.S. economy as well. The central bank didn’t say when it would file its appeal.
The Fed has refused to name the financial firms it lent to or disclose the amounts or the assets put up as collateral under the emergency programs, saying disclosure might set off a run by depositors and unsettle shareholders. Bloomberg LP, the New York-based company majority-owned by Mayor Michael Bloomberg, sued on Nov. 7 under the Freedom of Information Act on behalf of its Bloomberg News unit.
“Our argument is that the public interest in disclosure outweighs the banks’ interest in secrecy,” said Thomas Golden, a lawyer with New York-based Willkie Farr & Gallagher LLP who represents Bloomberg. Preska’s Aug. 24 ruling rejected the Fed’s argument that the records should remain private because they are trade secrets and would scare customers into pulling their deposits.
“What has the Fed got to hide?” said Senator Bernie Sanders, a Vermont independent who sponsored a bill to require the Fed to submit to an audit by the Government Accountability Office. “The time has come for the Fed to stop stonewalling and hand this information over to the public,” he said in an e-mail. The Clearing House Association LLC, an industry-owned group in New York that processes payments between banks, filed a declaration that accompanied the request for a stay.
“Experience in the banking industry has shown that when customers and market participants hear negative rumors about a bank, negative consequences inevitably flow,” Norman Nelson, vice president and general counsel for the group, said in the document. “Our members have accessed the discount window with the understanding that the Fed will not disclose information about their borrowing, especially their identity.”
Members of the Clearing House are ABN Amro Holding NV, Bank of America Corp., Bank of New York Mellon Corp., Citigroup Inc.Deutsche Bank AG, HSBC Holdings Plc, JPMorgan Chase Inc., UBS AG, U.S. Bancorp and Wells Fargo & Co.
Clunkers and Home Sales – It’s All the Same Thing
by Bruce Krasting
The car clunker program was a huge success. Close to 700,000 cars were sold as a result of the program. The cash rebate was the down payment that was necessary for consumers to borrow more money and buy a car. The clunker concept has now been extended to washing machines. No doubt that the availability of government rebate checks will stimulate demand for these products as well.
It will be very interesting to follow car sales over the next few months. The sales volume will fall, as the stimulus to buy is no longer there. The question will be: “ Did the clunker program just steal from future consumption, or has there been a permanent increase in demand that reflects a stronger economy? My bet is that the demand is going to fall flat. I visited a car dealer on Tuesday and they had not seen a customer. Without the rebate there are no buyers.
There is another clunker like program that is out there stimulating demand. It is focused on the low end housing market. Given the huge success of car clunkers it is reasonable to assume that this segment of the housing market is being positively influenced by the subsidy. The question here will be whether that stimulus is responsible for the improved housing numbers that have surfaced over the past few months.
The American Recovery and Reinvestment Act (ARRA) of 2/17/2009 created an $8,000 tax credit for first time home buyers. The number of homes that have been sold as a result of this program is not clear at this time. As I drive around my neighborhood I see many For Sale signs that highlight the $8,000 credit. Until the success of the car clunker program I thought that this incentive was not a significant factor. I have revised my own view regarding its impact on the housing market.
The ARRA established an estimate of $3b as the cost of the housing subsidy. The actual results could vary significantly from that estimate. It depends on how many buyers take advantage of the program. The full $8,000 is available to only a defined group of buyers. The rebate is limited to not more than 10% of the home to be purchased. Therefore one has to buy a home equal to not less than $80,000 to get the max. Another restriction is on individual/family income. Above $150,000 of household income the tax credit is phased out.
These variables make it difficult to predict how significant the stimulus results are. We will not know the exact answer until the IRS reports on this. That is a next year event. For the sake of discussion assume that this program is working as planned and that the number of homes sold as a result of the incentive is prorated equally over the life of the program. $3b divided by $8,000 comes to 375,000 homes. The program will expire at the end of November; therefore an estimate of the number of homes sold under the program from inception to date would be 250,000.
How significant is this in the home sales rebound that we seem to be witnessing? My answer is that it is a big factor. Housing sales are running at a rate close to 5mm per year. During the six months that the housing rebate program has been in place approximately 10% of the homes sold were a result of the program.
It is likely that the full benefits of the program were not felt until May 19th of this year. At that time HUD created the opportunity for a buyer to use the $8,000 as a down payment provided that the borrower obtained an FHA insured mortgage. FHA can insure up to 97.5% of a purchase price. This means that the equity of $8,000 could have been used to finance a 100% purchase. If one was wondering why there are the endless ads for FHA mortgages on cable TV, this is your answer. The cash that can be created along with the high LTV FHA loans makes it possible once again to buy a home with no money down. The three months that this 100% financing window has been open are the same three months where housing has turned around. That is not a coincidence. We’ve seen this before. It sells homes. It raises values. It looks good. But it creates a tremendous headache.
Given that the bulk of the stimulus was felt post 5/19 it is possible that as much as 20% of the sales over the last three months were tied to the rebate. Without that contribution we would not have seen any recovery in home values over the past three months.
These stimulus measures work. That has been proven. But these programs are not sustainable. The budget deficit is already too large. At some point the music has to stop with all of the economic intervention. When that happens the economy will have no boost. Economic activity will suffer. We have bought some time with all of the subsidies for consumption. That time is running out.
1%+ real economic growth for 2010 will be difficult to achieve unless Congress passes a second stimulus program. The question will be whether the money to fund these stimulus measures can be borrowed at a cost we can afford. The other question will be if the dollar can hold up in the face of America’s continued dependence on debt as the only driver of consumption.
The ability to expand the stimulus programs will be dependent on the will of the Markets as much as the will of the Administration/Congress. At the end of August there is no evidence of unfriendly markets. September and October are not likely to be as friendly.
FDIC's Coffers Are Depleted, It May Need Help
The coffers of the Federal Deposit Insurance Corp. have been so depleted by the epidemic of collapsing financial institutions that analysts warn it could sink into the red by the end of this year. That has happened only once before — during the savings-and-loan crisis of the early 1990s, when the FDIC was forced to borrow $15 billion from the Treasury and repay it later with interest.
The government agency that guarantees depositors against the loss of their money in a bank failure may need its own lifeline. The FDIC on Thursday will disclose how much is left in its insurance fund, and update the number of banks on its list of troubled institutions. That number shot up to 305 in the first quarter — the highest since 1994 and up from 252 late last year. FDIC Chairman Sheila Bair may also use the quarterly briefing to discuss how the agency plans to shore up its accounts.
Small and midsize banks across the country have been hurt by rising loan defaults in the recession. When they fail, the FDIC is responsible for making sure depositors don't lose a cent. It has two options to replenish its insurance fund in the short run: It can charge banks higher fees or it can take the more radical step of borrowing from the U.S. Treasury. None of this means bank customers have anything to worry about.
The FDIC is fully backed by the government, which means depositors' accounts are guaranteed up to $250,000 per account. And it still has billions in loss reserves apart from the insurance fund. Because of the surging bank failures, the FDIC's board voted Wednesday to make it easier for private investors to buy failed financial institutions. Private equity funds have been criticized for taking too many risks and paying managers too much.
But these days fewer healthy banks are willing to buy ailing banks, and the depth of the banking crisis appears to have softened the FDIC's resistance to private buyers. Under the new rules, a buyer would need to maintain the failed bank's reserves at levels equal to 10 percent of its assets. An earlier proposal set the requirement at 15 percent.
The new policy also eases the rules on when private investors must maintain minimum levels of capital that might be needed to bolster banks they own. But the FDIC sought to guard against private equity funds that might want to quickly buy and sell at a profit: It required the investors to maintain a bank's minimum capital levels for three years.
At least in theory, allowing private investors to buy failing banks would mean the FDIC could charge a higher price, shrinking the amount of losses the agency would have to cover. Bair has not ruled out hiking premiums on banks for the second time this year or asking the Treasury for a short-term loan. She has said taking the longer-term step of drawing on the Treasury credit line is only for emergencies.
So far this year, 81 banks have failed, compared with just 25 last year — and only three in 2007. Hundreds more banks are expected to fall in coming years because of souring loans for commercial real estate. That threatens to deplete the FDIC's fund. "I think the public should expect the fund to go negative at some point," said Gerard Cassidy, a banking analyst at RBC Capital Markets, which has predicted that up to 1,000 banks — or one in eight — could disappear within three years.
Either lifeline for the FDIC carries risks. Borrowing from the Treasury could be seen as another taxpayer bailout. But charging more in premiums would shrink profits at healthy banks, squeeze troubled ones and make lending even tighter. "The more you levy these assessments on banks, the less money they have to lend to the general population," said Camden Fine, president of the Independent Community Bankers of America, an industry group that represents 5,000 banks.
Last week's failure of Guaranty Bank in Texas, the second-largest this year, is expected to cost the FDIC $3 billion. The FDIC recorded more than $19 billion in losses just through March. The agency figures it will need $70 billion to cover bank failures through 2013, more than five times the $13 billion that was in the fund in March. The last time it was that low was during the S&L crisis in 1992, when the fund was down to $178 million. Some critics say regulators have taken too long to shut down troubled banks. Chicago's Corus Bankshares, for example, has staggered for weeks under the weight of bad real estate loans.
FDIC spokesman Andrew Gray said the agency seeks to strike a balance between helping troubled banks work through their problems "so there's zero cost to the deposit fund," and intervening quickly if there are no other options.
Is The Fed Enabling Foreign Central Banks To Swap Out Their Agency Debt Into Treasuries?
Another quite intriguing piece by Chris Martenson "The Shell Game - How The Federal Reserve Is Monetizing Debt" reveals some of the intricacies of the Fed's monetization game and, by digging deeper into the Fed's Custody Account, demonstrates not just how the Federal Reserve is enabling foreigners to swap out of Agencies into Treasuries, but how it is implicitly monetizing a markedly larger portion of debt than is assumed.
For the full details of the article we eagerly refer readers to the original Martenson piece, but in a nutshell here are the components of what Martenson coins "The Fed's Shell Game":
It is no secret that capital flows into the US have declined precipitously, a fact that can be substantiated by TIC flows and by the St. Louis Fed:
Comparing this data with TIC releases, indicates that from January to May the total capital outflows from the U.S. amount to ($314) billion in assets, consisting of central bank purchases of $50 billion, however, matched with private investor dispositions of $364 billion.
Ignoring the implications of what this decline would mean for an economy that relies exclusively on credit growth in order to perpetuate the monetary Ponzi scheme that the US economy has been for years, the simple conclusion here is that a combination of declining consumer credit and foreign interest for US debt purchases has very negative implications for the credit bubble the Federal Reserve is trying to reflate. As for the consequences for the U.S. Dollar as a result of this activity, these have recently become all too clear.
All well and good up to here.
However, what is very troubling is what Martenson points out is the cumulative change in the Fed's Custody Account, which at last check was roughly $2.8 trillion, and represented by Martenson's chart below:
Martenson provides a good explanation of what the function of the Custody Account is:
The Federal Reserve actually holds the bonds (or rather an electronic entry representing the bonds) in a special account for these various central banks. This is called the "Custody Account" and it holds US debt 'in custody' for various central banks. Think of it as a magnificently vast brokerage/checking account, run by the Federal Reserve for central banks, and you'll have the right image.
Indeed, while TIC may indicate one thing, an observation of the CA indicates that foreigned have in fact been accumulating substantial amounts of US debt since the crisis began in earnest, at a rate that has not budged from its long-term average.
Yet the concerning conclusion by observing the above chart is the dramatic divergence in the CA of Treasury versus Agency holdings. Says Martenson:
Here we note that agency bonds peaked in October of 2008 at nearly a trillion dollars but have declined by $178 billion since then. Treasuries, on the other hand, have increased by over $500 billion over that same span of time. A half a trillion dollars! If you were wondering how the US bond auctions have managed to go so smoothly, here's part of your answer.
At this point it bears pointing out the Fed's balance sheet, where the Fed's large appetite for agencies (including MBS for the purposes of this analysis) is evident. I present the most recent Federal Balance sheet as presented on Zero Hedge a week ago:
May this be an explanation of what is happening:
It would appear that foreign central banks have been swapping agency bonds for Treasury bonds, but that's not how the markets work. First, they would have to sell those bonds, before they could use the proceeds to buy government debt. So to whom did they sell those Agency bonds in order to afford the Treasury bonds?
And here is where the concept of the appropriately coined Shell Game comes into play:
These are the three critical points to remember as you read further:
- The US government has record amounts of Treasuries to sell.
- Foreign central banks, which have a big pile of agency bonds in their custody account, would like to help but want to keep things somewhat under the radar to avoid scaring the debt markets.
- The Federal Reserve does not want to be seen directly buying US government debt at auctions (and in fact is not permitted to, but many rules have been 'bent' worse during this crisis), because that could upset the whole illusion that there is unlimited demand for US government paper, but it also desperately wants to avoid a failed auction.
For various reasons, the Federal Reserve cannot just up and start buying all the Treasury paper that becomes available in record amounts, week after week, month after month.
Instead, it uses this three-step shell game to hide what it is doing under a layer of complexity:
Shell #1: Foreign central banks sell agency debt out of the custody account.
Shell #2: The Federal Reserve buys those agency bonds with money created out of thin air.
Shell #3: Foreign central banks use that very same money to buy Treasuries at the next government auction.
The question arises, where are the agencies that the Fed is purchasing at such as gluttonous pace coming from? Absent an audit of the Fed, one can merely speculate, but likely is one of the primary motivations for the Federal Reserve Chairman and the Secretary of the Treasury to claim that any additional openness into the activities of the Fed would be "problematic to the country."
Would this "behind the scenes" rotation endorsed by the Fed, whereby the Custody Account is the middleman for Foreign-Fed transactions, be the primary reason for an apparently unwavering indirect interest in US Treasuries?
As Martenson concludes:
The Federal Reserve has effectively been monetizing far more US government debt than has openly been revealed, by cleverly enabling foreign central banks to swap their agency debt for Treasury debt. This is not a sign of strength and reveals a pattern of trading temporary relief for future difficulties.
This is very nearly the same path that Zimbabwe took, resulting in the complete abandonment of the Zimbabwe dollar as a unit of currency. The difference is in the complexity of the game being played, not the substance of the actions themselves.
The shell game that the Fed is currently playing does not change the basic equation: Money is being printed out of thin air so that it can be used to buy US government debt.
When the full scope of this program is more widely recognized, ever more pressure will fall upon the dollar, as more and more private investors shun the dollar and all dollar-denominated instruments as stores of value and wealth. This will further burden the efforts of the various central banks around the world as they endeavor to meet the vast borrowing desires of the US government.
One possible result of the abandonment of these efforts is a wholesale flight out of the dollar and into other assets. To US residents, this will be experienced as rapidly rising import costs and increasing costs for all internationally-traded basic commodities, especially food items. For the rest of the world, the results will range from discomforting to disastrous, depending on their degree of dollar linkage.
As more and more people dig behind the Fed lustrous facade, increasingly more troubling discoveries are made. On one hand you see POMO auctions that repurchase recently auctioned off securities; on the other - potential capital rotation via custodial accounts of which there is no mention in mainstream media venues. If this analysis is in fact correct, the Fed is monetizing not only the Treasuries it purchases via POMO, but effectively also the indirect bidders' treasury interest, which is represented by their rolling out of agencies purchased by the Fed, and the newly raised cash used for UST purchases. Has the Fed essentially monopolized the entire Treasury Auction process?
Whether this speculation of dollar abusive policies by the Federal Reserve, which will stop at nothing, to reinflate the credit bubble and debase dollar-based debt, is in fact true, is questionable. However, definitive answers from Chariman Ben will not be forthcoming until he is forced to show his hand, whether via a legal order such as the recently won Bloomberg lawsuit, or through political means, such as HR 1207 and S 604. In the meantime, it appears the Federal Reserve, whose accountability should be to the entire US population, not just to a select crowd of Wall Street oligarchs, continues to pursue activities that facilitiate at any and all cost the stratification of US society into that minority that will benefit vastly from the Fed's ongoing actions and the significant majority who will see the purchasing power of the paper in their wallets gradually disappear, and effectively put the entire concept of the "American Middle Class" at risk.
For the full link to Chris Martenson's article, please click here.
Merrill Ruling Could Hit Wall Street Lawyers Where It Hurts
For years the white shoe law firm Wachtell Lipton Rosen & Katz has been the envy of its competition thanks to its phenomenal profits-per-partner, which were $4 million in 2008. But that figure could take a hit in the wake of a decision Tuesday from the federal judge overseeing the Bank of America-Merrill Lynch bonus dispute.
In Tuesday's ruling, Judge Jed S. Rakoff of the U.S. District Court for the Southern District of New York suggested lawyers involved in the controversial merger might "be held legally responsible" for the creation of a late 2008 proxy statement from Bank of America that incorrectly informed shareholders the bank wouldn't let its new acquisition, Merrill Lynch, pay out $5.8 billion in discretionary year-end bonuses.
The inaccurate proxy statement prompted the Securities and Exchange Commission to call for a $33 million penalty. But the feds want the burden to fall to shareholders--and, Rakoff notes, "arguably indirectly on U.S. taxpayers"--instead of individual wrongdoers associated with the misleading proxy statement.
The reason? Bank of America higher-ups told the SEC they "relied entirely on counsel to decide what was or was not disclosed in the proxy statement." Because such discussions are protected by attorney-client privilege, the SEC reasoned in court papers submitted to Rakoff, it will remain a mystery why the bonus information got left out of the proxy. That logic didn't score any points with Rakoff, who called attention to a 2006 SEC statement promising the commission would seek penalties from wrongdoing corporate insiders, not shareholders.
"If the SEC is right in [its] assertion [about Bank of America's attorney-client privilege], it would seem that all a corporate officer who has produced a false proxy statement need offer by way of defense is that he or she relied on counsel," Rakoff wrote.
In defense of their proxy disclosure, Bank of America's spokesperson has said the shareholders were presented with "the strategic logic" of the merger, seemingly suggesting they would not have been interested in the payment of bonuses. But the SEC's investigation reveals that payment of the Merrill bonuses was one of five key topics during the merger negotiations. Bank of America agreed to let Merrill pay out 2008 bonuses that were equal to the 2007 payout of $5.8 billion even though Merrill had already planned to cut its payout to $5.1 billion in 2008 due to its poor performance.
As the SEC argued to Rakoff, the $5.8 billion in bonuses that Bank of America authorized Merrill to pay constituted nearly 12% of the $50 billion that Bank of America had agreed to pay to acquire Merrill and amounted to nearly 30% of Merrill's total stockholder equity. Rakoff told the SEC and Bank of America to submit more briefs on the attorney-client privilege issue by Sept. 9. Bank of America won't be able to settle its SEC case until Rakoff approves of the terms.
Wachtell Lipton represented Bank of America in the Merrill deal, with partner Edward Herlihy, known for his longtime ties to Bank of America chief Kenneth Lewis, playing a key role in the merger.
Wachtell's earnings have skyrocketed in recent years as the economy boomed. Its partners averaged profits of no less than $3 million every year since 2004, according to American Lawyer's annual surveys. Over that period, it's ranked highest among U.S. law firms in profits-per-partner every year but 2006, when it was ranked second highest. In 2007 that figure was just below $5 million. That year ended with Herlihy helping Bank of America seal its $4 billion takeover of doomed mortgage lender Countrywide Financial.
Wachtell is not the only prestigious law firm potentially in the hot seat. Lawyers at Shearman & Sterling (22nd in profits-per-partner among U.S. law firms last year, with $1.7 million) represented Merrill Lynch in the merger. A Shearman spokesperson declined to comment on the possibility the firm would itself be held liable for the inaccurate proxy and resulting penalty. Wachtell's spokesperson did not immediately respond to a request for comment on that issue.
Secret 2007 Presentation Alerted World Finance Leaders Of Coming Collapse"
This happy band of G7 finance ministers looked perfectly relaxed as they arrived for their gathering in Washington in April 2007.
But it now turns out that they were all given a secret 60-minute presentation which warned of the dangers of toxic US subprime loans infecting banks across the world - and the risk they posed to the entire global financial system.
Jim Chanos, the hedge fund chief who made his name predicting the collapse of Enron, was invited along with fellow hedgie Paul Singer to brief Gordon Brown (then Chancellor) et al. Hedge funds (along with private equity firms) were being targeted by Europeans as the devil incarnate and so were invited by the American govt to put their case.
Chanos has now revealed that the pair of them warned of "radioactive" securitisations held by banks - and even named those his firm was shorting. But they were "officially ignored" by the G7 ministers.
Chanos picks up the story (forgive me quoting at length but it's worth it):
"It was the April 07 G7 Finance ministers meeting in Washington. It was a rotating chair and the Germans were rotating the meetings. And at the time if you recall the Germans were quite concerned about hedge funds and private equity as being a future source of problems in the market place.
"And Bob Steel, who was the Under-Secretary to the Treasury, who was fighting these German efforts at the time, felt that it would be helpful if two hedge fund managers came down and address the finance ministers and central bankers on the last day. So I was invited along with Paul Singer, who has gone public now, he was the other manager.
“Paul got up and proceeded to give a tour de force presentation on the coming crack-up in structured finance, how all these structures were very unstable and triple A [the ratings given to the securities] was not going to be triple A..."
The meeting was just five months before the run on Northern Rock and more than a year before Lehman Brothers collapsed.
Chanos and Singer pointed out that HSBC had announced that January that its US sub-prime loans were going bad at 'an alarming rate'.
“So there were some canaries in the coal mine by April 07 and Paul pointed them out,”
"I then segued into my presentation which told the assembled regulators that in fact if Mr Singer was correct and I believed he was, that the problem would not be hedge funds it would be the regulated banks and brokers who were leveraged 30-1, many of which held glowing, toxic radioactive pieces of securitisation which they could never sell.
"The German finance minister who was chairing the meeting thanked me politely and then thanked Paul and said 'so what do you think about Hedge Funds?'“
So despite having received this stark warning, the only response from the politicians was 'yeah, yeah but what about tightening up regulation on you guys?'
Mr Chanos, founder of Kynikos Associates, said that immediately after the presentation, the G7 ministers issued a statement continuing to insist that their economies were strong and made no mention of the warnings. Check out the G7 Communique of the time - you won't find a clearer example of the complacency of world politicians and regulators.
“We were completely and officially ignored,” said Chanos.
When asked if anyone present had subsequently had apologised for failing to heed the warnings, Mr Chanos replied:
“Two people, but they shall go nameless - and unfortunately, nobody still in power today.” That means G Brown was definitely not one of those who apologised for not listening.
Chanos added that he had even named individual banks that were at risk.
“At that meeting I even disclosed that the entities I’m now putting up on the wall are leveraged 30 to one - you should worry about virtually all of them and you should be concerned, but I am betting with my clients’ money that there’s going to be a big problem here. So there was no doubt as to where I stood on the situation.”
I heard Chanos' dynamite quotes while listening to Robert Peston's excellent documentary on Radio 4 "Peston and the Money Men" this week. Pesto is clearly on holiday and no one at the Beeb has spotted the goldust buried in the programme.
You can hear the key section HERE (listen from 12m 40s)
Chanos also makes a robust defence of hedgies, pointing out that many pension funds now act as clients, and says there is no evidence at all that short-selling drove the banking collapse.
A bit of digging shows that on the day of the fateful G7 meeting - ironically it was Friday 13th - Gordon was still blithely confident that the global economy was going great guns.
"We have always wanted the world economy to fly on more than one wing," he said ahead of the meeting, claiming that China and India were doing ok so there was nothing to worry about.
He was also confident America's sub-prime mortgage crisis would be contained, arguing it was "not a worldwide phenomenon".
Ah, how wrong, wrong, wrong he was.Shadow Chancellor George Osborne has now seized on Chanos' remarks. "We all know Gordon Brown didn’t fix the roof when the sun was shining - and here it appears is yet another example of him getting clear advice at the time that that was a mistake," he tells me.
UPDATE: The Treasury has a response.
A spokesman says: "The reality is, no one anticipated the scale or synchronised nature of the global financial crisis that struck in 2008. There is no doubt it was fuelled by excessive risk taking by many financial institutions around the world. The UK Government acted decisively to avert the collapse of our financial system and through the G20 we are working to ensure we learn the lessons of the crisis and reform the system for the future."
FURTHER (4pm) UPDATE: Vince Cable, the Lib Dems' Treasury spokesman, has now weighed in:
"It would appear that Gordon Brown failed to listen to any of the warnings of the brewing financial storm. Had these concerns been listened to earlier, the situation we faced need not have been so grave."
Measuring the Damage of our 'Water Footprint'
A Dutch hydro engineer has come up with a "water footprint." At a conference in Sweden, he and other participants discussed water waste, supermarkets filled with fruits and vegetables produced in some of the world's most arid regions and ways we can stop wasting our most precious resource. Arjen Hoekstra didn't really stand out in the crowd of 2,000 scientists, activists, politicians and representatives of industry roaming the halls of the Stockholm trade fair. Far more attention-getting figures than the 42-year-old Dutch hydro engineer attended World Water Week in Sweden last week. Asian delegates wore glowing saris. And Indian businessman Bindeshwar Pathak drew flocks of media everywhere he went at the event after being named the recipient of this year's Stockholm Water Prize for inventing a toilet for slum dwellers.
But Hoekstra preferred to keep a low profile at the annual global conference, which focuses on water-related issues. He had nothing to prove. Still despite his apparent efforts to keep a low-profile, Hoekstra's creation served as a magnet for debate here. Hoekstra came up with the idea of the "water footprint." His equation is actually just a couple of numbers used to describe the amount of water that is used -- or polluted -- during the manufacture of various products.
Anyone can calculate their water footprint by looking at the amount of water they use directly and then by looking at the amount of "virtual water" they use -- that is, how much water is used in the production of any goods they consume. The global average for an individual's water footprint is 1,243 cubic meters of water per year. In the US, this goes up to 2,483 cubic meters per year; in Germany it's 1,545 and in China, 702.
Hoekstra's water footprint formula has already made headlines around the world with its estimates of the amount of water that is used or abused in the simple products that are a part of our everyday lives:
- 140 liters of water for one cup of coffee!
- 2,400 liters for a hamburger!
- 10,000 liters for one pair of jeans!
In the dicussions and workshops in Stockholm, participants debated what sort of action should be taken as a result of the water footprint figures. The WWF environmental group first recognized the validity of the water footprint, and further conservation and environmental protection groups as well as the United Nations and the World Bank soon followed suit. Finally, even multinational companies like Nestle, Unilever and Pepsi got on board.
And they all seem to agree that Hoekstra's numbers could be potentially explosive -- mainly because they make it clear how thoughtlessly water, the most precious of resources, is handled in so many areas. "Because of the international trade in water-intensive products, there are floods of virtual water flowing around the world," Hoekstra said. "And many of them are flowing in the wrong direction, going from water-poor regions to the water-rich."
Mostly these flows involve food, biofuels and cotton. Between 70 and 80 percent of all the water consumption in the world is used for agricultural purposes. The European Union, for example, contributes indirectly to the drying out of the ever-shrinking Aral Sea in Kazakhstan and Uzbekistan through its cotton imports from the region. And when the Germans buy ham from Spain or oranges from Israel, they are also contributing to water scarcity in those areas. In fact, Germany, a country that has plenty of water, is one of the biggest importers of virtual water in the world.
Today, around 1.4 billion people live in areas where water is scarce. Climate change, population growth and the flows of virtual water only serve to exascerbate the problem. "By 2050, we will be confronted with the paradoxical situation of having to feed another 2.5 billion people, but with significantly less water," said Colin Chartres, director general of the International Water Management Institute, an internationally funded, non-profit organization looking into ways to improve land and water management.
Against that backdrop, delegates in Stockholm argued about how realistic Hoekstra's more radical ideas are. "In dry areas there should be no more agriculture," the Dutchman has suggested. His idea involves using the trade in virtual water to rebalance the earth's water budget. Instead of watering desert fields, Egypt would be better off importing beans or millet from Ethiopia, for example. And Australia, where the Outback is one of the world's most arid regions, should also cease to export virtual water in the form of meat, fruit and wine production.
The same arguments could be applied to all of Earth's dry zones -- from the Middle East to northern China and northwestern India to Southern California. Hoekstra says all of these regions could mitigate their water paucity by letting their fields dry up and importing more virtual water. "These water-poor regions need to come up with a new vision for the future," Hoekstra argued. "Just as the oil producing countries, where oil is starting to run out, have had to do."
But what would make any country abandon agriculture, altogether or partially? British environmental researcher Tony Allan, 72, first coined the phrase "virtual water" in the 1990s and he agrees with Hoekstra. "Singapore is an interesting example," he said. "They don't have water sources or agriculture. Ninety percent of their water needs are covered by the import of virtual water. The rest comes from recycling and desalination."
Of course, Allan knows that Singaporean model isn't necessarily appropriate for the rest of the world. Even he admitted that no country would voluntarily give up its agricultural practices in the foreseeable future. "But it is no longer taboo to talk about these things," he noted. During the Stockholm workshops, experts quickly agreed that new pricing structures could steer the water trade in the right directions. Today, water prices are often distorted through government subsidies to farmers -- mainly because if the subsidies were not there, then agriculture and animal husbandry would very quickly become prohibitively expensive in those dry regions and no longer worthwhile.
Meanwhile, countries like China and Saudia Arabia are buying up large, fertile pieces of land in places like Africa, Asia and Latin America. By buying land instead of food, they are ensuring access to water in the future. The land-grabbing countries aren't alone, either -- they're competing directly with food production giants like Nestle and Coca-Cola, which have been buying up rights to water reservoirs around the world for years. Many companies are welcoming the increasing debate about water footprints in Stockholm. It's a great opportunity for them to do something to improve their image. Indeed, several large corporations sent whole delegations to Stockholm. At the workshops, the delegates continually repeated the same message: Their employers are trying their very best to leave a smaller water footprint.