War workers at home, Washington, D.C.
"A radio is company for this girl in her boardinghouse room"
Ilargi: It's often as amusing as it is surprising to me how readers react when I quote people who are perceived as being right-wing. My view is quite rudimentary: I’m not interested in the dividing lines in politics, but since I think a society needs to take care of its weakest, simply to survive, the only wing I seem to have is a left one. I also think a government needs to have a strong voice within a society, but as a force representing its people, not as some kind of separate entity. If people don't feel their government speaks for them, they should get rid of it and get another, hard as that may be. The present rule of corporatism in countries such as the US is, then, not my idea of democratic representation.
Sometimes I quote the alleged right-wing to show how wrong their ideas are. And sometimes I quote them because they have interesting things to say and/or because they are simply right. If there's one thing I take for granted today, it's that we need all the good ideas we can lay our hands on, no matter where they originate.
In a few recent interviews in which Max Keiser talks to Mish Shedlock , I once again noticed that Mish and I see a lot of things the same way. Still, when his libertarianism rears its head, I’m out of here. And I agree with Max that Mish's view of Ben Bernanke is far too benign.
Still, Mish, in the interview, cites a recent survey among 15,000 economists in which only 12(!) among them said deflation is the main economic threat going forward, not inflation. Neither Mish nor I were surveyed, but we both whole-heartedly agree with that view. I have long clamored for the demise of Fannie and Freddie and their perverting role in the US housing market, and Mish agrees with me on that.
Another voice who shares the deflation view is Howard Davidowitz, who in a recent talk at Tech Ticker basically says that with retail sales tanking as they do, which will force hundreds of thousands of stores to close, inflation is not even a possibility, a view reinforced by the overdose of toxic assets that remain in the banking industry and will lead to hundreds of additional bank failures. Davidowitz claims that Obama's budget and spending numbers "have all gone mad", and really, you don’t need to be right-wing to make that claim. I for one fully agree, and you won't see me at no tea party.
Yet another much maligned voice is Ambrose Evans-Pritchard at the Telegraph in London. I agree which most criticism of the man’s ideas, but I don’t care about his ideas, it's his facts and data that I want. So let's start there with a series of quotes and numbers that hopefully wake up another few among you to the difference between green shoots and recoveries on the one hand, and real life on the other. Here's Ambrose today:
Our quarter-century penance is just starting
- "[..] we are exhausting the limits of fiscal stimulus. "The average ratio of debt to GDP in the G-20 economies was high before the crisis, and is forecast to exceed 100% in the next few years". We cannot add debt, so the IMF says we must draw down our future pensions and future health spending to keep today's economy afloat.
- "A modest cut in the growth rates of entitlements can buy substantial fiscal space for continuing stimulus." Shouldn't bulls be sobered that the bastion of hard-nosed orthodoxy feels the need to talk in such terms, or that White House officials are preparing the ground for another round of emergency spending even as it reveals that fiscal deficits will reach $9 trillion over the next decade."
- "All that has happened over this crisis is that huge private losses have been dumped on society: but the losses are still there, smothering the economy. Taxes must rise. Debts must slowly be purged."
- "As long as economic growth relies on the state, you cannot talk about durable recovery," said European Central Bank member, Yves Mersch."
That is real life: spend tomorrow's pensions and health care funds to keep banks afloat today. And those are Obama's numbers, no matter where you feel at home in the political spectrum. Spending has become a religious ritual, with Bernanke, Krugman and many others as masters of ceremony. Interestingly, Ambrose seems to have defected from their camp.
An issue raised by both Davidowitz and Max Keiser are the fast rising assumptions of US budget deficits, reports of which came out the past week. Davidowitz, rightly, points out that it's crazy the government raises its 10-year deficit estimate by $2 trillion, or almost 30%, in August from March. With him, I wonder: what's next? Keiser sees the numbers as proof of the terrible financial future the US is locked in for, and he's right too.
US says debt outlook worsening
- The announcement came as the White House projected the budget deficit would be $2,000 billion higher over the next 10 years than it had predicted. Taken with a separate forecast by the independent Congressional Budget Office, the news presented a bleak picture of America’s deteriorating debt position. The CBO released sharply higher deficit projections predicting the 10-year deficit would reach $7,140 billion, some $2,700 billion more than it had thought in March. Unlike the White House’s calculations, the CBO estimate assumes all policies will stay exactly as they are.
- Karl Case, joint creator of the widely watched S&P Case-Shiller home price index, said its latest data showing a second consecutive monthly rise in house prices showed that the “boat has turned” in the US housing market. “That’s very good for the future of this financial problem. It is real and it looks like a turn” [..]
No, Mr. Case, no boat has turned in the housing market, people just buy their neighbors a home without knowing it, through Fannie and Freddie, and that "smart plan" is fast running out of breath too. Once the Fed is done swapping foreign-held GSE debt for Treasuries, an activity Chris Martenson unearthed, they’ll need a whole new paradigm. Not that they're not working on one, mind you.
How bad is that future? Rolfe Winkler thinks he can provide a peek into tomorrow. He talks about a Wall Street Journal article that came out before Sunday's elections in Japan. The sitting government has lost. The one that won has promised a lot of public spending.
Peering into our future…
- The party that’s been in power for 59 years will likely lose the elections to another, which promises “ambitious spending programs” despite Japan’s huge debt.
- Incomes continue to fall. Inflated artificially by a credit bubble, Japan’s per capita income once ranked 4th in the world, but has since fallen to 14th.
- Declining birth rates mean younger Japanese don’t have the voting power to reduce entitlement spending that’s asphyxiating the economy.
US numbers for now, are a little bit better than Japan's, but the difference is shrinking fast. US public debt stands at $11.73 trillion, the present budget deficit is $1.24 trillion. The US, however, also has $7.4 trillion in private debt, a number that is in all likelihood much lower in savings-oriented Japan.
Noteworthy is Winkler's assertion that the younger generation doesn't have the votes to lower their parents' benefits. That is a major threat to social stability in all rich countries, though one not felt as strongly in the US.
There are notions developing about a US dollar carry trade emerging, much like the one that existed in the yen and which financed a substantial part of last decade's global boom. The way I see it developing is that a financial institution borrows USD at close to zero%, buys Treasuries at 3.25% (or thereabouts), while at the same time shorting for instance both the dollar and the Treasury. Perhaps long oil or gold, short dollar, or vice versa. It seems no problem to create a position, with the difference between the dollar and government debt, in which you virtually cannot lose. And if investors cannot lose, another party cannot win. Guess who, taxpayer?
So how about that recovery that is so direly needed to pay for all the spending? According to the Financial Times, the perhaps biggest reason for the rally of the past 5 months has been short sellers needing to cover their positions. AIG's meteoritic 264% rise in "value" can probably be -almost- fully explained this way: shares went up because they were so hard to get.
And now the shorts are retreating. It may take another month or so, perhaps even two, depending on where they are invested, but they will go. An in my opinion very sobering thought is that the stocks that have been shorted most heavily are those that have received most in taxpayer funds. Think about that for a second, let it sink in.
'Shorters' retreat helps fuel volatility
- Short sellers have been deserting the US stock market in droves during its sluggish summer sessions in a retreat that has helped fuel the recent volatile trading in AIG and other beaten-down financial shares, analysts said on Friday. [..] When large numbers of short sellers close their positions by buying shares at the same time, the stocks involved can register explosive – and often inexplicable – gains.
- [..] the S&P has climbed steadily in August to its highest levels in 10 months, with some of the best performing stocks being those that were most heavily sold short – AIG, Fannie Mae, Freddie Mac and Citigroup.
The shorts are not the only sign the rally has no long distance legs. Corporate insiders, people who work for the companies they hold stock in, sell off 30 times more of that stock than they buy. These are the people who ostensibly see the books. They don't seem to like them. Charles Biderman may vote Republican, but I will quote him regardless. He's right: the economy is in much worse shape than conventional wisdom believes.
Insider Trading and Investor Sentiment Signaling U.S. Stock Market Top
- [..] selling by corporate insiders in August has surged to $6.1 billion, the highest amount since May 2008. The ratio of insider selling to insider buying hit 30.6, the highest level since TrimTabs began tracking the data in 2004. "The best-informed market participants are sending a clear signal that the party on Wall Street is going to end soon," said Charles Biderman, CEO of TrimTabs.
- "When corporate insiders are bailing, the shorts are covering and investors are borrowing to buy, it generally pays to be a seller rather than a buyer of stock," said Biderman. TrimTabs also reports that the actions of U.S. public companies have been bearish. In the past four months, companies have been net sellers of a record $105.2 billion in shares.
- "Investors who think the U.S. economy is recovering are going to get a big shock this fall," said Biderman. "Companies and corporate insiders are signaling that the economy is in much worse shape than conventional wisdom believes."
But, you say, how about the consumer, who makes up 70% of GDP? Well, I'm sorry, and by all means don't shoot the messenger, but consumer sentiment is down. The New York Times doesn't quite seem to get it though. They still talk about a "Reluctance to Spend", but that's not the issue at hand. For the past ten years, if not more, Americans have had to borrow to spend, and always more at that.
Reluctance to Spend May Be Legacy of the Recession
- Given that consumer spending has in recent years accounted for 70 percent of the nation’s economic activity, a marginal shrinking could significantly depress demand for goods and services, discouraging businesses from hiring more workers.
- Millions of Americans spent years tapping credit cards, stock portfolios and once-rising home values to spend in excess of their incomes and now lack the wherewithal to carry on.
- Between 2003 and 2007 — prime years of the housing boom — the net worth of an American household expanded to about $540,000, from about $400,000, according to an analysis of federal data by Moody’s Economy.com. Now, the wealth effect is working in reverse: by the first three months of this year, household net worth had dropped to $421,000.
Phantom home price increases, and loans, home or other, handed out with each purchase of a carton of laundry detergent, have made this look like a natural phenomenon for a while, but it is of course no such thing. There is, for one thing, not so much a reluctance to spend as there is a reluctance to borrow, and for those who would like to borrow, they’ll find lenders with a reluctance to lend.
U.S. credit card issuers pare lending limits
- Credit Suisse analyst Moshe Orenbuch estimated available credit card lines will be cut by about 20 percent, or $1.2 trillion, in coming months, and warned that "further cuts could result from the provisions of the new credit card law." Meredith Whitney, one of Wall Street's best known and most bearish bank analysts, forecast that [..] credit card lines will be cut by $2.7 trillion, or around 50 percent, by the end of 2010.
- "Much of the credit line reduction to date has been driven by inactive account elimination, and I think in some respect you are seeing now a contraction in credit lines to individuals that are active," said Sanjay Sakhrani, an analyst at KBW. Going forward, credit card companies will purge customers rather than risk higher losses.
- American Express, the largest U.S. credit card company by sales, posted the biggest June decline, 2.6 percent, while Bank of America showed the largest cumulative decline since October 2008, 28.6 percent, Orenbuch added.
Get out of the way, people. This is not going to end well. Look at the data. Get out while you can. Ambrose gives it a quarter century. Howard Davidowitz says it’ll never come back. Take your pick, believe what you must, tickle your fancy, but please do try to get it into your thick skulls that "salvation is just around the corner" is not among the options on offer. Not the earthly kind, that is.
Our quarter-century penance is just starting
Never in modern times has there been such a flat contradiction between the euphoria of markets and the stern warnings of officialdom at central banks and financial watchdogs. Corporate credit has seen the steepest rally in almost a hundred years, according to Morgan Stanley. Hedge funds are reviving the final bubble play of early 2007, writing put options on long-dated "volatility" contracts to wring out extra profit. It is as if the Great Contraction – as the Bank of England now calls it – was just a random shock, as if we should naturally expect "V-shaped" resurgence to take us back to where we were. Yet that is what precisely we are being told will not and cannot happen.
"The current financial crisis is unlike any others," says the Bank for International Settlements. Lasting damage has been done. The "cumulative output loss" is likely to reach 20pc of GDP in the major economies. The message is the same at the International Monetary Fund. "The world is not in a run of the mill recession. The crisis has left deep scars. In advanced countries, the financial systems are partly dysfunctional," said Olivier Blanchard, the Fund's chief economist. Mr Blanchard said an IMF study of post-War banking crises led to an unpleasant finding. "Output does not go back to its old trend path, but remains permanently below it."
Then the sting: we are exhausting the limits of fiscal stimulus. "The average ratio of debt to GDP in the G-20 economies was high before the crisis, and is forecast to exceed 100pc in the next few years". We cannot add debt, so the IMF says we must draw down our future pensions and future health spending to keep today's economy afloat. "A modest cut in the growth rates of entitlements can buy substantial fiscal space for continuing stimulus." Shouldn't bulls be sobered that the bastion of hard-nosed orthodoxy feels the need to talk in such terms, or that White House officials are preparing the ground for another round of emergency spending even as it reveals that fiscal deficits will reach $9 trillion over the next decade. This is $2 trillion worse than feared in March, and based on rosy growth assumptions.
It has certainly alarmed US retail tycoon Howard Davidowitz. "As a country we are out of control, we're in a death spiral," he said. All that has happened over this crisis is that huge private losses have been dumped on society: but the losses are still there, smothering the economy. Taxes must rise. Debts must slowly be purged. "As long as economic growth relies on the state, you cannot talk about durable recovery," said European Central Bank member, Yves Mersch.
Nobel Laureate Paul Krugman said the US needs another fiscal blast for "political reasons", alluding to the Great Depression. It was Phase II from late 1931 to early 1933 that tipped half Europe into fascism and brought America soup kitchens. Although such a fate has been averted this time by government action, the Atlanta Fed says the true rate of US unemployment is already 16pc (not 9.4pc), worse than early 1931 levels. Official youth unemployment is 34pc in Spain, 28pc in Latvia, 25pc in Italy, 24pc in Sweden, Hungary, and Greece.
I have some sympathy with the Krugman view, but entirely disagree over methods. The key is to prevent a debt deflation trap – note that producer prices have fallen 8.5pc in Japan, 7.8pc in Germany, and 6.8pc in the US. The least dangerous medication is Quantitative Easing a l'outrance (ie printing money), as the Bank's Mervyn King clearly thinks. This does not add debt. It prevents the real value of existing debt from rising. Mr Krugman undermined his case by citing Italy as a country that faced public debt of 118pc of GDP in the early 1990s without disaster. Actually, it has caused disaster, even if it has taken this recession to expose the damage. Debt will rocket to 125pc next year (IMF forecasts), and then -- one fears – off the charts.
We know what caused this crisis. The West kept short-term interest rates too low for a quarter century, luring society into debt: and the East held down long-term rates by flooding bond markets as a side-effect of their mercantilist strategy (ie suppressing currencies to gain export share). The outcome was over-investment, excess capacity, and too much debt among those supposed to buy the goods. Has any of this changed? No. Have we cleared the excess plant? No. Jeff Wenniger from Harris Private Bank says an army of baby-boomers have seen their old age plans shattered by the housing bust. Their nightmare is here. They will have to spend less, and save more. "Generational destruction of a society's balance sheet down not rectify itself in a matter of months". How about a quarter century?
'Shorters' retreat helps fuel volatility
Short sellers have been deserting the US stock market in droves during its sluggish summer sessions in a retreat that has helped fuel the recent volatile trading in AIG and other beaten-down financial shares, analysts said on Friday. Short sellers seek to profit from price declines by selling borrowed shares and then “covering” their positions with purchases of the same stocks. When large numbers of short sellers close their positions by buying shares at the same time, the stocks involved can register explosive – and often inexplicable – gains.
Although stocks gave back some of their gains in early trading on Friday, the S&P has climbed steadily in August to its highest levels in 10 months, with some of the best performing stocks being those that were most heavily sold short – AIG, Fannie Mae, Freddie Mac and Citigroup. Analysts say short sellers have been closing many of their positions in recent weeks. Short interest as a percentage of S&P 500 stocks fell to its lowest level in eight months by mid-August, according to the most recent data. Bespoke Investment Group said average short interest in other major equity indices had fallen to the lowest levels since at least October 2007.
“The US Fish and Wildlife Service may have a new candidate for its endangered species list,” said Paul Hickey of Bespoke. “It’s short sellers.” Closing short positions has been particularly difficult recently because of low summer volumes. At the same time, trading - which is now dominated by rapid-fire computer systems - has become fragmented across exchanges and various electronic platforms. The result has been agony for short sellers of stock such as AIG, who have been squeezed, in the market place, as they try to buy shares to close their positions. AIG shares [have] soared 260 per cent since early August.
”Trading volumes are somewhat lower and centred around a few stocks that have been in play among short sellers,” said Gordon Charlop, managing director at Rosenblatt Securities. The low volumes and resulting short squeeze, in turn, have cast doubt on the current rally’s sustainability. “There is less legitimacy about the rally in the last week as it has been based on low volumes,” said Jim Paulsen, chief investment strategist at Wells Capital Management. Analysts said they expect that in September, fundamentals will return as the main driver of equity prices.
AIG officials declined to comment on the share price. But people close to the company said executives attributed the sharp rise in the stock to a combination of a short-sellers covering their positions and a widespread stock market rally. The said recent strong performances in the broader market had increased investors’ expectations of the value of the large businesses AIG has to sell in order to repay some $80bn in federal aid. Recent comments by Robert Benmosche, the insurer’s new chief executives, suggesting the company will slow down its disposals programme in order to reap as a high a price as possible also helped, according to people familiar with the matter.
Insider Trading and Investor Sentiment Signaling U.S. Stock Market Top
TrimTabs Investment Research reported that selling by corporate insiders in August has surged to $6.1 billion, the highest amount since May 2008. The ratio of insider selling to insider buying hit 30.6, the highest level since TrimTabs began tracking the data in 2004. "The best-informed market participants are sending a clear signal that the party on Wall Street is going to end soon," said Charles Biderman, CEO of TrimTabs. TrimTabs' data on insider transactions is based on daily filings of Form 4, which corporate officers, directors, and major holders are required to file with the Securities and Exchange Commission.
In a research note, TrimTabs explained that insider activity is not the only sign the rally is about to end. The TrimTabs Demand Index, which tracks 18 fund flow and sentiment indicators, has turned very bearish for the first time since March. For example, short interest on NYSE stocks plummeted by 10.3% in the second half of July and margin debt on all US listed stocks spiked 5.9% in July, while 51.6% of advisors surveyed by Investors Intelligence are bullish, the highest level since December 2007.
"When corporate insiders are bailing, the shorts are covering and investors are borrowing to buy, it generally pays to be a seller rather than a buyer of stock," said Biderman. TrimTabs also reports that the actions of U.S. public companies have been bearish. In the past four months, companies have been net sellers of a record $105.2 billion in shares. "Investors who think the U.S. economy is recovering are going to get a big shock this fall," said Biderman. "Companies and corporate insiders are signaling that the economy is in much worse shape than conventional wisdom believes."
U.S. credit card issuers pare lending limits
Millions of Americans have already seen their credit card limits shrink, and millions more face the same fate as lenders prepare for tougher U.S. consumer protection rules. Since the financial crisis deepened a year ago, credit card companies have been closing millions of inactive accounts, cutting credit limits and raising interest rates to cushion themselves from record loan losses.
This is just the beginning of the biggest shake-up in the credit card industry in at least 20 years, analysts said. Credit Suisse analyst Moshe Orenbuch estimated available credit card lines will be cut by about 20 percent, or $1.2 trillion, in coming months, and warned that "further cuts could result from the provisions of the new credit card law." Meredith Whitney, one of Wall Street's best known and most bearish bank analysts, forecast that unused credit card lines will be cut by $2.7 trillion, or around 50 percent, by the end of 2010.
"Much of the credit line reduction to date has been driven by inactive account elimination, and I think in some respect you are seeing now a contraction in credit lines to individuals that are active," said Sanjay Sakhrani, an analyst at KBW. Going forward, credit card companies will purge customers rather than risk higher losses. Sakhrani said customers likely to be cut off are subprime borrowers with weak credit and those who switch lenders, lured by "teaser" rates.
For years, credit card issuers courted borrowers with offers of no annual fees and low interest rates. Lenders could later increase those charges if the clients were late in their payments or exceeded their credit limits. But a new law signed recently by President Barack Obama forces credit card companies to warn customers about changes in contractual conditions. Starting in February, lenders will face even more restrictions on imposing fees and raising interest rates. Unable to ramp up these sources of revenue, issuers worried about losses are expected to cut back on lending.
"If you have customers lower down the credit spectrum you routinely repriced and you can't do that anymore, you may see card issuers decide that they don't want to extend lines to them anymore," Sakhrani said. Credit card companies also anticipate they will raise fees and rates before the new law takes effect. "If you assume that the average consumer has five cards, right now most of those cards don't carry an annual fee. If you start charging an annual fee on those cards, the consumer may end up having only three cards," said Scott Valentin, an analyst at FBR Capital Markets. "That will have a big impact in the industry's total available credit."
Credit Suisse's Orenbuch forecast credit card mail volume will be down 65 percent this year from 2008. "We expect volume to remain well below historical levels, given the economy and new card regulations," he said. Existing customers will also have less credit to tap. According to a study by credit scoring company FICO, formerly known as Fair Isaac, 33 million Americans had their revolving credit reduced between October 2008 and April 2009. That is up 25 percent from the previous six months. And there are more cuts to come. In a recent survey by the Federal Reserve, 60 percent of banks said they expected credit card lending standards to remain tight at least until 2011.
Total credit card lines, both used and unused, declined in June at the largest credit card issuers. Total lines at American Express Co, Bank of America Corp, Capital One Financial Corp, Citigroup Inc and JPMorgan Chase & Co declined by a combined $32.1 billion, or 1.2 percent, in the month, Orenbuch said. American Express, the largest U.S. credit card company by sales, posted the biggest June decline, 2.6 percent, while Bank of America showed the largest cumulative decline since October 2008, 28.6 percent, Orenbuch added.
American Express recently canceled 2.7 million cards that had not been used for 24 months and had no outstanding balance, Chief Financial Officer Daniel Henry said last month. David Nelms, chief executive of Discover Financial Services, said his company was reducing the number of new accounts created. Valentin estimated credit card firms could close one of every five accounts of subprime borrowers, a segment of the market where Citigroup and Bank of America have the biggest exposure. "You will see a lot less credit available," he said.
Peering into our future…
A WSJ article on Japanese elections comes with the following table.
Japan has spent 20 years fighting deflation with loose monetary policy and deficit spending. To what end? Keynesians point to Japan’s experience as evidence that the U.S. government can borrow much more before interest rates rise. I suspect they’re right. But what’s the point if, at the end of all of that, we’re saddled with unpayable debts? Sure, deficit spending prevented more violent economic upheaval last year. But the more debts we build up, the longer and deeper the downturn will prove to be over time.
The article has many interesting details…
- The party that’s been in power for 59 years will likely lose the elections to another, which promises “ambitious spending programs” despite Japan’s huge debt.
- Incomes continue to fall. Inflated artificially by a credit bubble, Japan’s per capita income once ranked 4th in the world, but has since fallen to 14th.
- Declining birth rates mean younger Japanese don’t have the voting power to reduce entitlement spending that’s asphyxiating the economy.
My hope is that America finds the political will to deal with debt. If we don’t, even matching Japan’s sorry trajectory will be tough.
Thanks to the Deficit, the Buck Stops Here
by Joseph Stiglitz
Beware of deficit fetishism. Last week we learned that the national debt is likely to grow by more than $9 billion. That's not great news -- no one likes a big deficit -- but President Obama inherited an economic mess from the Bush administration, and the cleanup comes with an inevitably high price tag. We're paying it now. There are no easy options. When financial crises strike, economic growth declines and living standards drop, resulting in lower tax revenues and greater need for government assistance -- all of which leads to higher fiscal imbalances.
What really matters is not the size of the deficit but how we're spending our money. If we expand our debt in order to make high-return, productive investments, the economy can become stronger than if we slash expenditures. There are other consequences, however, that we're missing in the debate over all this red ink. Our budget deficit, as well as the Federal Reserve's ballooning lending programs and other financial obligations, will accelerate a process already well underway -- a changing role for the U.S. dollar in the global economy.
The domino effect is straightforward: Higher deficits spark market concerns over future inflation; concerns of inflation contribute to a weaker dollar; and both come together to undermine the greenback's role as a reliable store of value around the world. Right now, with so much unused capacity in the American economy and so much unemployment -- likely to persist for at least another year or two -- the more pressing worry is deflation (a general decrease in prices), not inflation. But as the economy eventually recovers, the possibility of inflation will loom, and with forward-looking markets, worries about the future often play out in the present. Anxieties about future inflation can lead to a weaker dollar today.
So, are these anxieties justifiable? And what do they portend for the global financial system? The worries are justified, even though Fed Chairman Ben Bernanke, recently nominated for another four-year term, assures us that he will deftly manage monetary policy to keep the economy on an even kilter. This is a tough balancing act -- move too quickly or too vigorously, and you plunge the economy into another downturn; too slowly or too weakly, and inflation can be unleashed. Anyone looking at the Fed's record in recent years will be skeptical of its forecasting skills and its ability to get the balance right.
In addition, international markets understand that the United States may face strong incentives to reduce the real value of its debts through inflation, which makes each dollar owed worth less. If market players are worried about inflation (or even if they are worried that others might be worried) that is bad news for the dollar. Holding dollars today represents risk without reward: The returns to U.S. Treasury bills are near zero, and even those most confident in the Federal Reserve must acknowledge the chance that things will not go smoothly.
For decades, other nations have held dollars in their central bank reserves, seeking to give confidence to their country and currency. But in a globalized economy, why should the entire financial system depend on the vagaries of what happens in America? The current system is not only bad for the world, it is bad for the United States, too. In effect, as other countries hold more dollar reserves, we are exporting T-bills rather than automobiles, and exporting T-bills doesn't create jobs. We used to offset this drag on the economy by running a fiscal deficit. But going forward, we won't find it as easy to do this. And the Fed may not be able to do the trick -- as we have learned, expansionary monetary policy poses its own risks.
Like it or not, out of the ashes of this debacle a new and more stable global reserve system is likely to emerge, and for the world as a whole, as well as for the United States, this would be a good thing. It would lead to a more stable worldwide financial system and stronger global economic growth. The current system entails developing countries putting aside hundreds of billions of dollars a year -- only weakening global demand and contributing to our economic difficulties. Also, there is something a little unseemly about poor countries lending the United States trillions of dollars, now at an interest rate of close to zero.
Discussions on the design of the new system are already underway. The United Nations' Commission of Experts on Reforms of the International Monetary and Financial System -- a body I chaired and which included economists, former and current government officials, financial sector participants, central bankers, and business leaders from Asia, Europe, the United States, Africa, and Latin America -- has argued that a new global reserve currency system may be the most important reform to ensure the long-term health of the world's economy; it also suggested how to design an orderly transition from the dollar-based system.
In its interim report in June, the commission described a number of alternatives. Some involve building on the International Monetary Fund's "special drawing rights," or SDRs -- a kind of "IMF money" -- but making the issuance of this global reserve money annual and more predictable. (Currently, issuances of SDRs are small and episodic.) Other proposed reforms are more complex and ambitious, such as issuing new global reserves in ways and amounts that could be used to stabilize the world's economy or to invest in "global public goods," such as helping developing nations reduce greenhouse gas emissions.
The United States has resisted these changes, but they will come regardless, and it's better for us to participate in the construction of a new system than have it happen without us. The United States has seen great advantages with the dollar as the world's reserve currency of choice, particularly the ability to borrow at low interest rates seemingly without limit. But we haven't seen the costs as clearly: the inevitable trade deficits, the instability, the weaker global economy. The benefits to us are likely to shrink, and rapidly so, as countries shift their holdings away from the dollar.
It is happening already, and the process is likely to accelerate. Chinese authorities, for example, have openly expressed concerns about the value of the country's vast dollar reserves. Not surprisingly, China and other nations holding lots of U.S. debt support efforts to build a new system. America should show leadership in helping shape this new structure and managing the transition, rather than burying its head in the sand. We may have preferred to keep the old system, in which the dollar reigned supreme, but that's no longer an option.
Halting Recovery Divides America in Two
The U.S. recovery is a tale of two economies. At one extreme of Corporate America is a cadre of companies and banks, mostly big, united by an enviable access to credit. At the other end are firms, chiefly small, with slumping sales that can't borrow or are facing stiff terms to do so. On Main Street, there are consumers with rock-solid jobs -- but also legions of debt-strapped individuals struggling to keep their noses above water. This split helps explain the patchiness of the recovery that appears to be taking hold after the worst recession in a half-century.
Panera Bread, a St. Louis-based national chain of more than 1,400 cafes, is a rare winner in its industry. With more than $100 million in cash and no debt, it is demanding, and getting, cut-rate leases from landlords. Panera's occupancy costs have come down 10% to 20% since last year. It is hiring and expanding into spaces formerly occupied by Blockbusters and Bennigan's. "For us, this is the best of times," says Ron Shaich, its chief executive. "Cash is king and this is a buyer's market." Business is tougher for Panera franchisees. They can still borrow -- but at a price.
Mike Hamra, who owns 47 Panera restaurants in the Boston and Chicago areas, says he is paying a full percentage point more on his loans than he paid last fall. "Banks are not throwing money at us," Mr. Hamra says. AquaSpy Inc., a maker of high-tech irrigation gear for farmers, has similar headaches. Its customers want to see stable production before placing big orders, says Cynthia Jamison, the acting chief financial officer, while some suppliers demand up-front payment. These are "the bumps in the road that are driven by being cash-poor," she says. AquaSpy's staff has shriveled to 26 from 80 the past few years.
The split between companies that can borrow and those that can't shows the extent to which any recovery depends on reviving the nation's ailing banks and squeamish credit markets. Until that happens, the vigor of the economy will remain in doubt. "If you're not making money, you need to borrow money," says John Graham, a finance professor at Duke University's Fuqua School of Business. But "you need to be creditworthy in order to borrow, and if you're not making money, you're creditworthiness isn't very strong." Mr. Graham, who oversees a quarterly survey of CFOs, says more companies are doing better than they were a few months ago. Still, he estimates, one in four is in "dire straights due to lack of profits combined with not being able to borrow."
Companies big enough to bypass banks and go directly to capital markets are finding a warmer reception. That's because the markets are showing more willingness to make risky loans: In January, only eight of the 56 companies that sold bonds were rated below-investment-grade, or "junk," according to Dealogic. In August, by contrast, 24 of the 60 deals had junk ratings. Since the start of the year, companies have been increasingly turning to the bond markets to raise money. Through August thus far, companies have issued $395.4 billion in bonds over 512 deals, according to Dealogic, a healthy increase from the second half of last year when the markets went months with fewer offerings and less than a handful of junk bond deals.
One test of a recession's end is evidence that companies are willing to take risks buying other companies. Here, too, "there is a bifurcation of the market," says Jeff Raich, head of mergers and acquisitions at investment bankers Moelis & Co. "Once you see lower-credit-quality companies get access to loans, that will be a sign the capital markets are turning." One hopeful sign is the recent $3.1 billion purchase by Warner Chilcott Ltd. of Procter & Gamble's pharmaceutical business. The buyer managed to get a $4 billion leveraged loan -- a loan to an already highly indebted borrower -- to do the deal and refinance the debt. "If it was a smaller company, that deal would have been more difficult to finance," Mr. Raich says.
But many firms dependent on banks are finding credit tougher to come by. In the Federal Reserve's latest survey of senior loan officers, conducted in July and released in mid-August, about 35% of banks said they had raised lending standards since April for nearly all business borrowers, regardless of size. The rest left them unchanged, which is to say much tougher than a couple of years ago. Most banks said they are charging business customers more, relative to the banks' cost of funds.
"We are absolutely managing and making decisions based on ... our relationship with the bank," says Bob Klotz, CEO of Bayside Solutions Inc., a temporary-staffing firm with a multimillion-dollar credit line from a "major bank." The bank raised rates about three months ago and has increased the financial reporting it requires "tenfold" compared to last year. That has prompted the Pleasanton, Calif., firm to turn away less-creditworthy clients -- including other small businesses -- which are more likely to file for bankruptcy or fall behind on payments. "We're not in a position where we can take that risk," he says. Mr. Klotz estimates that Fortune 1000 companies represent 80% of his business now, up from 60% previously.
As sales slowed and cash flows tightened earlier this year, Bayside laid off 15 employees (mostly recruiters and salespeople) and abandoned low-margin business lines, like placements for light-industrial workers and back-office staff, where competition from temporary-staffing behemoths Manpower Inc. and Adecco SA is fiercer, says Mr. Klotz. He now employs about 60 full-time staffers. "We've been put through the wringer," says Mr. Klotz. The company is doing "a lot more due diligence" on every potential customer.
Northland Aluminum Products Inc. in Minneapolis, maker of Bundt pans and Nordic Ware, played it safe during the boom times and kept a rainy-day fund. So when the recession struck, it decided to use it as a chance to expand. It's in the midst of a $5 million project to increase its capacity by 40% to 50%. "I went out in October looking for money, and I had banks fighting over the deal," says David Dalquist, Northland's chief executive. He says four banks made proposals to him. "We lived within our means and conserved ourselves," Mr. Dalquist says of the privately held company. "Now we're in a position to take advantage of these difficult times." He says business is up 8% this year, mainly because Northland is grabbing market share from struggling rivals. Meantime, the construction bust means the plant expansion cost about 25% less than it might have a few years ago. "There are a lot of hungry contractors," Mr. Dalquist says.
In the business of finance itself, a divide between early winners and others appears to be opening up as well. Many of the nation's biggest financial institutions, benefiting from federal-government backing, have been able to raise equity and debt from private investors. Some large money-management companies such as BlackRock Inc. are profiting by helping the Treasury with the clean-up from the burst bubble. Some of the nation's largest banks could, in fact, emerge from the crisis stronger than they entered it. While they have suffered huge losses on complex financial products, and are still facing mounting loan defaults, they were stabilized with tens of billions of dollars of taxpayer money. In the second quarter, the seven largest commercial banks earned more than $14 billion, even as thousands of smaller banks were in the red.
Big lenders are currently enjoying an advantage in their "cost of funds" -- the raw material of a bank, which is in the business of borrowing cheaply and lending at a higher rate. The handful of banks with more than $10 billion in assets were paying 1.18% to borrow money in the second quarter, the FDIC said in data issued Thursday. By contrast, banks with $100 million and $1 billion in assets were paying 1.97%, a big difference in a business where tenths of a percentage point translates into millions of dollars in profits.
Usually it is the other way around -- small banks pay less. But large banks have always obtained a much larger share of their funding from sources other than deposits, such as borrowing short-term from other banks at the federal funds rate, which is largely set by the Federal Reserve. With the Fed holding that rate near zero, large banks are benefiting more than smaller banks. Some big banks, like J.P. Morgan Chase & Co., U.S. Bancorp, PNC Financial Services Group Inc. and BB&T Corp., have cemented their megabank status by gobbling up rivals that were seized by regulators. As of June 30 the three largest banks -- Bank of America, Wells Fargo, and J.P.Morgan -- collectively had $2.3 trillion in domestic deposits, or 31% of the industry total, according to the Federal Deposit Insurance Corp. Two years earlier, the top three had only 20% of the industry total.
Working for a big bank doesn't necessarily offer much job security, however. At the height of the boom, Andrea Caroline, 27 years old, was pulling down $160,000 a year at J.P. Morgan Chase's subprime-mortgage division as an account executive. Then the market collapsed. She was laid off in March 2008. After sending 300 copies of her résumé, she's still looking for a new job. She says that the word "subprime" on her résumé has conjured suspicion among prospective employers. "They think I was stealing money. And I have to say: 'Look, I wasn't doing anything personally. All I'm asking for is another opportunity.' "
Ms. Caroline moved in with her parents to save on rent, and she turned in her BMW as a voluntary repossession, unable to keep up the $800-a-month payments. While Ms. Caroline is an individual using plastic to try to get by, credit-card debt is also a tool famously used by small businesses to finance themselves. There's bad news here as well, since card issuers are clamping down on lending as well. In the most recent Fed survey of senior loan officers, about one in four banks said they had decreased the limits on business credit cards over the past three years; only one of 33 banks had increased. Most bankers said their standards for credit-card loans to their best customers would remain tighter than normal into 2011 or beyond.
Overall, as is often the case after a rash of banking problems, smaller banks accuse government regulators of over-reaction, while regulators say the bankers are reluctant to fess up to their mistakes. It is easier for regulators to go after smaller banks, says Robert Hartheimer, a Washington, D.C., banking consultant and former head of the FDIC's Division of Resolutions. "Small banks' loans tend to be concentrated in the hardest-hit sectors of the economy," such as local real-estate lending, he points out.
Whatever the cause, would-be borrowers feel the pain. Riverview Community Bank of Vancouver, Wash., which serves the Portland, Ore., region, has cut back lending in the past year under pressure from regulators to increase its capital levels -- which means either raising new capital, or shrinking its assets. The bank's loan portfolio declined 24% this year from the first quarter to the second, according to FDIC data. The bank isn't renewing loans when they come due, said Ronald Wysaske, its president. He expects the bank to remain in a defensive crouch, with little appetite to lend more, for at least another year. "I'd hate to think that it would last longer than that," he says.
The Five Stages of Panic Buying
I talk to a ton of traders, portfolio managers, brokers and high net worth investors, both on and off Wall Street. Most of them have engaged in a bit of panic buying at some point this summer as the 50% rally in US stocks surprised many smart players. Panic buying is what happens when you run money for a living and you feel like you’re missing a huge upside move. To make up for lost performance, your purchases get more aggressive than usual.
For all I know, the rally could end today and it will still be one for the record books. Lots of people weren’t ready for it. This post is dedicated to the guys and gals who were able to adjust, despite what their quant models, economic indicators or magic Roubini email blasts were telling them. The quotes below are real, if paraphrased, and came from a variety of my contacts and friends (love you guys, don’t hate me!).
The Reformed Broker presents: The Five Stages of Panic Buying!
- Denial (Late March/ Early April)
• “Ha, another Bear Market rally…wait til the foreclosure/ new home sales/ confidence data comes in! Right back to 6500, maybe lower…bagholders”
• “Dude, the stress tests are coming out next month. B of A may be done-ski. Sell the May 10 calls, you’ll never have to cover.”
- Anger (Mid-April)
• “What the f@&% do you mean the goddamn banks are cheap based on normalized earnings? They will never ever earn anything again, ever! Idiot!”
• “You gotta be kidding me with these retailers running now. RETAILERS? Are you nuts? They’re FINISHED!”
• “If one more consumer discretionary name rallies on a less-than-expected loss, I’m gonna kick this Bloomberg down a flight of stairs.”
- Bargaining (May-June)
• “Okay, I can stomach picking up some large cap tech and I’ll nibble – NIBBLE! – at discount retailers, but I will absolutely NOT buy Goldman Sachs at 130.”
• "If China would just pull back 5 to 7% I’d get in, but I can’t chase it here…except Sohu, and I guess a little Baidu and I’ll just take a quarter position in China Mobile just in case. But I’m not chasing here.”
• “(whispered) Dear market god, please stop the tape. Just give me one crack at the Nazz and some banks and I will never doubt the solvency of the US balance sheet or the wisdom of the Troubled Asset Relief Program ever again.”
- Depression (July)
• “I can’t believe I missed it. Those D-bags next to me are high-fiving after every earnings report. Hate those f@&%ing guys.”
• “How could Las Vegas Sands do this to me? I’ve been watching this stock go up for 900% now. Couldn’t just give me one chance to get in. I suck.”
- Acceptance (Early August)
• “That’s it! I don’t give a damn anymore, GET ME IN NOW! Forget the big ones, they’re already up too much, are there any $5 stocks left that haven’t done anything yet?
• “I gotta blow out this stupid GLD, it does nothing, sick of it and sick of hearing about inflation. Even Paulson blew it out. Get me some $2 biotechs and some midwest regional bank stocks, I gotta get poppin’ over here! We’re going to 10,000 baby!”
If hearing these words and phrases from somewhere outside of your own inner monologue was at all cathartic or helpful, then you’re welcome. I don’t care how smart you think you are, at some point this spring/ summer, we’ve all had to chase something. To panic buy is to be human, just make sure you weren’t the last one in and keep your eyes on the exits.
U.S. bank failure tally rises to 84 for 2009
Three more U.S. banks failed on Friday, bringing the total to 84 so far this year, as the industry continues to grapple with deteriorating loans on their books. Regulators shuttered Affinity Bank of Ventura, California, Bradford Bank in Baltimore, and Mainstreet Bank of Forest Lake, Minnesota, which in total are expected to cost the government's deposit insurance fund about $446 million.
The Federal Deposit Insurance Corp on Thursday reported that the insurance fund's balance stood at $10.4 billion at the end of the second quarter. But the agency also noted that the figure was adjusted to account for $32 billion set aside for expected failures over the next year. FDIC Chairman Sheila Bair said this week that bank failures will remain elevated as banks go through the painful process of recognizing loan losses and cleaning up balance sheets.
The total of 84 failures this year marks a sharp rise over the 25 last year, and the three failures in all of 2007. She noted that the banking industry's performance is a lagging indicator and will continue to suffer even as the economy begins to improve. The FDIC also reported this week that the number of institutions on its "problem" bank list grew to 416 at the end of the second quarter, from 305 the prior quarter. Problem banks are institutions whose regulatory rating has been downgraded due to issues related to liquidity, capital levels, or asset quality.
The agency's update on Thursday on the health of the banking industry came a day after the FDIC approved new rules on private equity investment in troubled banks, softening an initial proposal that critics had warned could scare away badly needed capital
After a Bumpy Ride, Back at Square One
In the last eight years, home prices in the United States have almost exactly kept up with inflation. But it has been a wild ride. During the period, the Standard & Poor’s Case-Shiller 20-city composite index of home prices rose almost 21 percent. The Consumer Price Index also rose almost 21 percent. The period, from June 2001 through the June 2009 figures that were reported this week, can be separated into two periods: the five-year boom and the three-year bust. There are limited indications that prices have started to rally in some areas, but the overall index’s move in June just kept up with inflation.
During the boom, home prices outpaced inflation by 10.7 percent a year for five years. During the bust, they plunged, trailing inflation by 13.6 percent a year. The accompanying chart shows the pace of home prices, adjusted for inflation, and also shows the wide sectional variations. At one extreme is Detroit, where the boom never came but the bust has been severe. Adjusted for inflation, prices there are now down by almost half over the eight-year period. At the other extreme is New York, where the boom was not nearly as strong as in some areas but a larger part of the gains have been retained. At the height of the period, New York prices had outpaced inflation by 62 percent. At the latest report, prices are still up by 20 percent more than inflation.
The Case-Shiller figures cover very large areas for each city. In New York, the region extends from Trenton up to New Haven. The figures reflect sales of single-family homes only, so Manhattan, a market that is dominated by apartments, has a very small impact. The maximum performance of various areas reflects the differing housing markets. In areas like Dallas, Denver and Charlotte, N.C., home prices never rose much more than inflation. Those areas had ample land available to spread out, enabling developers to meet demand without major price changes. In contrast, areas like Los Angeles, New York and Washington were largely built up, and developers had to go far from the city to find raw land. In addition, zoning and other rules sometimes limited or delayed building.
That explanation does not, however, help with the two desert booms and busts — Phoenix and Las Vegas, where speculation went wild despite ample land for expansion. At the height of the boom, new developments around Phoenix would announce plans to begin selling homes — as yet not even started — on a Monday and would-be buyers would spend the weekend in sleeping bags outside the development to get a chance to buy.
Many such “buyers” did not expect to ever move into the house, or even pay for it. Instead, they expected to sell their right to the house, at a profit, before construction was completed. When that strategy stopped working, it left a large supply of unoccupied houses to depress prices. Now foreclosures are still rising, even as home sales and prices seem to have stabilized. If the worst is over, it will have been a wild ride that ended very close to where it began, but with many people much worse off for the experience.
Leverage Rising on Wall Street at Fastest Pace Since '07 Freeze
Banks are increasing lending to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since the credit-market debacle began in 2007. Credit Suisse Group AG and Scotia Capital, a unit of Canada’s third-largest bank, said they’re offering credit to investors who want to purchase loans. SunTrust Banks Inc., which left the business last year, is “reaching out to clients” to provide financing, said Michael McCoy, a spokesman for the Atlanta-based bank. JPMorgan Chase & Co. and Citigroup Inc. are doing the same for loans and mortgage-backed securities, said people familiar with the situation.
“I am surprised by how quickly the market has become receptive to leverage again,” said Bob Franz, the co-head of syndicated loans in New York at Credit Suisse. The Swiss bank has seen increasing investor demand for financing to buy loans in the past two months, he said. Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6. The increase suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia or Ginnie Mae in Washington. Broader data on loans for investments isn’t available.
The increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments. The world’s largest financial institutions have taken $1.6 trillion in writedowns and losses since the start of 2007, helping to trigger the worst financial calamity since the 1930s, according to data compiled by Bloomberg. Lending to purchase loans rated below investment grade and mortgage bonds is part of this year’s recovery in credit markets.
Companies sold $889 billion of corporate bonds in the U.S. this year, a record pace, Bloomberg data show. The Standard & Poor’s 500 Index rose 52 percent since March 9, the best rally since the Great Depression. Some areas of the credit market haven’t returned to the levels from before the collapse in real estate. Lenders are also requiring more collateral for loans.
Banks arranged $61.8 billion of leveraged, or high-yield, loans this year, a 74 percent decline from the same period in 2008, and 91 percent lower than two years ago, Bloomberg data show. Leveraged loans are rated below Baa3 by Moody’s Investors Service and BBB- by S&P of New York. No bonds containing new mortgages have been sold this year, except those with government backing, according to industry newsletter Inside MBS & ABS of Bethesda, Maryland.
The Fed data on loans by primary dealers is down from $113.8 billion in 2007. The data reflects so-called reverse- repurchase financing, securities-lending agreements and other arrangements. Financing purchases of assets is filling cracks left by the government, whose lending programs to end the recession didn’t address some of the riskiest parts of the consumer and corporate debt markets. The Fed’s $1 trillion Term Asset-Backed-Securities Loan Facility can’t be used to buy residential mortgage bonds and leveraged loans. The Treasury Department’s $40 billion Public- Private Investment Program excludes the loans and mortgage bonds that are repackaged into new securities.
“There is a lot of political pressure on banks to lend and this is one form,” said Ratul Roy, head of structured credit strategy at Citigroup in New York. The Fed and government programs prompted sales of securities backed by auto loans, credit cards, equipment leases and auto-dealership debt. Yields on top-ranked debt backed by auto loans and credit cards have fallen by as much as 2 percentage points relative to benchmark rates. The yield premium has shrunk to less than 1 percentage point since TALF began in March, according to Charlotte, North Carolina-based Bank of America Corp. data. The average interest rate on loans for new cars declined to 3.88 percent in June, from 8.23 percent in January, Fed data show.
The Fed is also buying as much as $1.25 trillion of so- called agency mortgage bonds. Fixed-rate, 30-year mortgages to borrowers with good credit who put money down are 5.29 percent, according to North Palm Beach, Florida-based Bankrate.com, or 1.85 percentage points more than 10-year Treasuries. The gap was 3.05 percentage points at the end of 2008.
The increase in bank financing tracks a rebound in demand for securities and assets. Prices for leveraged loans tumbled to a record low 59.2 cents on the dollar on average Dec. 17, before rebounding to 83.5 cents on Aug. 27, according to the S&P/LSTA U.S. Leveraged Loan 100 Index. As much as 5 cents of the gains are partly attributable to “leverage coming back into the system,” according to Franz at Zurich-based Credit Suisse. The senior-most bonds backed by adjustable-rate Alt-A home loans, or those with little to no documentation of a borrower’s finances, have jumped to 52 cents, from a low of 35 cents in March, according to Barclays Plc in London. Top-rated commercial-mortgage securities soared to 90 cents on average, from 72 cents in February, Merrill Lynch & Co. index data show. Merrill is a unit of Bank of America.
The risk now is that new credit leads to more losses at a time when consumer and corporate default rates are rising. Company defaults may increase to 12.2 percent worldwide in the fourth quarter, from 10.7 percent in July, according to new York-based Moody’s. U.S. financial institutions probably will report more credit losses as commercial real estate falters through next year, James Wells III, the chief executive officer at SunTrust, Georgia’s biggest lender, said in an Aug. 24 speech to the Rotary Club of Atlanta. “If you lever up an asset at these already elevated prices, and the underlying fundamentals, like termites, start to chew through the performance of the security, at some point it becomes unsustainable,” said Julian Mann, who helps oversee $5 billion in bonds as a vice president at First Pacific Advisors LLC in Los Angeles.
Chimera Investment Corp., the New York-based mortgage-debt investor that raised $1.5 billion by selling stock last quarter to buy devalued assets, hasn’t taken banks up on their loan offers in part because the company isn’t sure it would be able to continue “rolling” the financing when it matures, said Matthew Lambiase, the company’s CEO. The lack of a “robust” market means lenders may have too much power to change terms, Lambiase said on a July 30 earnings conference call with investors and analysts.
Investments held with borrowed money by funds including Santa Fe, New Mexico-based Thornburg Mortgage Inc. and Peloton Partners LLP of London slammed the markets as retreating prices made banks wary about getting repaid. That triggered margin calls, collateral seizures and obligations to unwind, fueling the downward spiral in credit markets. Thornburg, a 16-year-old home lender, filed for Chapter 11 bankruptcy protection in May. Peloton, a hedge-fund firm run by former Goldman Sachs Group Inc. partners, shut its $18 billion ABS Fund.
Financing terms are more stringent than before credit markets seized up. Investors seeking loans to buy non-agency home-loan bonds typically must put down 35 percent to 50 percent, according to four investors and bankers whose firms are using or providing the leverage and didn’t want to be named because the negotiations are private. That compares to as little as 3 percent for top-rated mortgage bonds before the markets collapsed, according to Laurie Goodman, an analyst at Amherst Securities Group LP in New York. She was among Institutional Investor’s top-rated fixed-income analysts while at Zurich-based UBS AG from 2000 to 2008.
Banks are typically offering as much as $3 in financing for every $1 of equity investors in leveraged loans contribute, down from $6 to $7 before mid-2007, Barry Delman, a New York-based managing director of structured credit products at Scotia Capital, said in reference to so-called total return swaps. Scotia Capital is a unit of Bank of Nova Scotia in Toronto. The swaps are a type of derivative where a bank passes on returns or losses from a pool of loans to an investor.
The interest rate that investors are now being charged is usually between 2 percentage points and 2.75 percentage points more than the London interbank offered rate, according to Delman. Three-month Libor, or what banks charge each other for loans in dollars, was set at 0.36 percent yesterday, according to the British Bankers’ Association. Derivatives are contracts whose values are tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.
JPMorgan and Citigroup, the second- and third-largest U.S. banks by assets, are offering similar terms, according to investors. Tasha Pelio, a spokeswoman at JPMorgan, and Jeanette Volpi, a Citigroup spokeswoman, declined to comment. Both banks are based in New York. “To the degree leverage coming back represents a normalization of the markets, it’s a good thing,” said Michael Youngblood, a former mortgage-bond analyst who last year co- founded hedge fund Five Bridges Advisors LLC in Bethesda, Maryland. “But the idea it should be part of any permanent residential-mortgage-securities portfolio strategy is unwise.”
Trash is king as Lehman shares surge
It’s either a sign of sheer boredom on Wall Street, or an early celebration of the one-year anniversary of Lehman Brothers’ demise, but shares of the fallen invesment bank were red hot today. The stock rose some 200%. Take that AIG. For some inexplicable reason, shares of the bankrupt investment bank, which trade on the loosely regulated over-the-counter Pink Sheets, changed hands some 73 million times on Friday. That’s a lot of trading in a stock that’s been worthless for nearly 12 months.
Indeed, on a typical day, the average trading volume in Lehman shares is about 2.6 million. The last time Lehman’s stock came anywhere close to today’s trading volume was way back in October, about a month after the Wall Street firm filed for bankruptcy. Then again, today’s trading surge boosted Lehman’s closing stock price to 15 cents. It had been sitting around 5 cents for months. Better yet, Lehman now has a respectable market cap of $103 million–not too shabby for a small-cap company on the Pink Sheets.
Of course, this trading in Lehman is just crazy. There’s not good explanation for it. Just as there is no good explanation for the big surge in shares of American International Group. Maybe this is just a case of traders trading trash financials to score a quick profit because they can’t find anything else to trade.
Carbon Cap-and-Trade: A Government M&A Stimulus Plan?
Health-care overhaul may be on life support, and while the chances of carbon cap-and-trade legislation may not be appreciably stronger, the bill still is sparking some M&A chatter. A functioning carbon market in the U.S. would cook up deals in almost any sector with a big emissions footprint, including utilities, oil refiners and metal-makers, according to Michael Hill, global co-head of natural resources at Deutsche Bank.
Markets hate uncertainty and the expense of polluting has been anyone’s guess. “The cost of carbon will no longer be a question mark,” Hill said. “It will be a fact and in a short period of time the market can model that. …Obviously, it’s hard to do deals when people are unclear about value.” In particular, U.S. industrial companies will begin to look more attractive to companies in Europe, which has had a carbon market since 2005. While the U.S. power market has long looked good to foreigners, because Americans buy a relatively large amount of electricity per-capita and the regulatory structure here lends itself to rate increases, European companies have shied away from acquisitions because of the carbon question mark. They would likely be bolder if carbon had a price and a fixed supply.
Relatively “clean” utilities such as Xcel Energy, of Minneapolis, would command a premium, as would those that are buying or building wind turbines and solar panels, like New Jersey’s NRG Energy. Meantime, Hill said a cap-and-trade system would also heat up underwriting activity, as power companies would need to raise cash to bankroll new infrastructure for cutting emissions and to buy companies that create renewable energy. Michael Wong, an analyst who covers financiers and stock exchanges for mutual-fund tracker Morningstar Inc., said investment banks already have started maneuvering for the would-be windfall. Those, like Deutsche Bank, that deal in European carbon markets, will have a head-start.
At the end of June, a cadre of former bulge-bracket bankers led by Jeff McDermott, once the joint global head of investment banking at UBS, launched Greentech Capital Advisors, a New York boutique aimed at cultivating “green” deals. Goldman Sachs Group and private-equity shops such as First Reserve have been buying into the renewable-energy industry. Both companies own stakes in Blue Source, a Utah company that captures and stores carbon. Goldman Sachs also has agreed to buy the majority of the carbon offsets from E+Co., which builds renewable energy plants world-wide.
For now, burning carbon is still free. The House of Representatives passed a 1,300 page cap-and-trade measure in early July that the Senate will start chewing on when it comes back from August recess. Whether the bill still stimulate Wall Street’s specialty, trading, is another question. “Speculators” is a dirty word in D.C. these days, and there is a move to block finance firms from what would be a massive new commodity market.
Sen. Maria Cantwell, a democrat from Washington, has filed a stripped down 22-page cap-and-trade bill that would largely box out finance firms. Sen. Byron Dorgan, a democrat from North Dakota, has opposed carbon-trading altogether, arguing that it would be “a field day for speculation.” “It won’t be very long before we have derivatives,” Dorgan said late last month. “We’ll have swaps; we’ll have synthetic swaps. You name it; we’ll have all of them.
California state taxes going up because of deflation
California taxpayers just got hit with another increase in state income taxes, and it didn't require a vote from a single legislator. The culprit: deflation.
In 1982, California voters approved a proposition that indexed state income tax rates to inflation. So each year, the California Franchise Tax Board adjusts tax brackets and certain deductions and credits for inflation. The annual adjustment is tied to the California Consumer Price Index, and it usually goes up. Indexing is designed to prevent people from paying higher taxes as their incomes rise proportionately with inflation. But when inflation turns negative, indexing works in reverse. Tax brackets and credits are adjusted downward. If your income remains the same, the result is a tax increase.
The Franchise Tax Board has just released adjustments for 2009, and for the first time since 1983 they are down, reflecting a 1.5 percent drop in the California Consumer Price Index between June 2008 and June 2009. As a result, everyone's state taxes will go up by a modest amount this year. The amount will vary depending on taxpayers' income, whether they itemize deductions and how many personal exemptions and other credits they claim.
A single person with no dependents and $51,000 in adjusted gross income would pay an extra $41. A married couple with two dependents and $90,000 in income would pay $71 more, according to the Franchise Tax Board. (This assumes both parties take the standard deduction.) Once a taxpayer reaches the top tax bracket, the added tax doesn't change much no matter how much money they make. A married couple with two dependents and $1 million in income would pay only $79 more as a result of deflation.
This tax hike comes on top of two increases the state Legislature approved for 2009 - a 0.25 percentage point increase in tax rates and a sharp decline in the tax credit for dependents. Those increases will cost taxpayers much more than the deflation factor, says Gina Rodriquez, Sacramento editor with Spidell Publishing, which works with tax professionals. This is only one of many taxes and benefits that are being upended by deflation.
In California, property tax assessments are adjusted each year based on the change in the state Consumer Price Index for the 12 months ending the previous October. Through June, the index is down 0.7 percent. Proposition 13 limited the annual increase to 2 percent but didn't say exactly what would happen if there was deflation. The California Board of Equalization expects to announce next week whether property taxes will go down next year if the CPI is negative.
Some seniors are complaining because they probably won't get an increase in Social Security benefits next year because of deflation. Benefits are indexed each year to inflation, but by law can never go down. Federal taxes also are indexed to inflation. Adjustments for 2009 were announced in October and were based on the change in U.S. CPI for the 12 months that ended Aug. 31, 2008. Inflation during that period was positive, so adjustments were up. It's not clear what will happen in 2010 if inflation for the 12 months ending in August is negative.
"It's likely it would be down about 1.7 percent," says Mark Luscombe, principal tax analyst with publishing company CCH. Technically, the IRS could adjust brackets down, "but there is speculation the IRS might have enough wiggle room to leave it the same," thus preventing a tax increase. "The IRS is aware of the issue, but we are not speculating at this time," says IRS spokesman Jesse Weller.
In California, inflation-indexing started in the late 1970s. "The Legislature in 1979 had fully indexed the income tax for 1980 and 1981. An attempt to continue full indexing was vetoed by Gov. (Jerry) Brown on fiscal grounds," David Doerr writes in "California's Tax Machine." In 1982, California voters approved Proposition 7, which made inflation indexing permanent. The next year, inflation turned negative, but that didn't happen again until this year.
The Howard Jarvis Taxpayers Association, which fought for Proposition 7, does not object to the tax increase resulting from deflation. "Hey, fair is fair," says association President Jon Coupal. "If there is true deflationary pressure, then we're OK with those rates being adjusted accordingly." The tax increase will bring in much-needed revenue for the state, but not as much as it had factored into this year's budget. "We thought (deflation) would be 2.2 percent," says H.D. Palmer, a spokesman for the state Department of Finance. Because deflation was only 1.5 percent, "There is actually going to be a marginal hit to the state's bottom line."
The state has not broken out how much tax revenue it expects from the deflation factor. Justin Garosi, an economist with the Legislative Analyst's Office, estimates that if deflation had been 1.5 percent in 2006, (the last year for which tax data is available) it would have raised about $295 million (factoring in an adjustment for the change in the dependent credit). By comparison, a quarter-point increase in rates in 2006 would have brought in about $2 billion. The new tax rate schedules were released to professionals last week and will be posted this week at www.ftb.ca.gov.
It’s Hard to Worry About a Deficit 10 Years Out
Ten years ago, Washington was worried about the budget outlook, and there were forecasts of dire outcomes. And so it is today. The difference is the nature of the worries. Alan Greenspan, then the Federal Reserve chairman, talked about the dangers of a shortage of Treasury securities as the $5 trillion surplus forecast for the next decade enabled the national debt to be paid down. This week we were warned of a $9 trillion deficit over the next 10 years.
“The last time people got really excited about a 10-year budget outlook, they were hysterically wrong about what transpired,” said Robert Barbera, the chief economist of ITG, who mocked the surplus forecasts then and now thinks the consensus outlook is too negative. “The $5 trillion surplus was a ‘nothing can go wrong’ forecast,” he said. “No recessions, no wars, no bear markets and a perpetuation of inexplicably high tax receipts. You can make the case that the current conversations about our fiscal outlook are effectively, ‘Nothing can go right.’ The estimates assume we continue to allocate over $100 billion a year for fighting wars. They assume a very mild recovery for the economy, and an even milder recovery for tax receipts.”
It was easier a decade ago to know the forecast was foolish, although few did. The assumption that politicians would refrain from cutting taxes or raising spending in the face of large surpluses had no historical support. On the other hand, the notion that politicians will point fingers and do nothing as deficits mount has plenty of historical support.
One unusual factor now is that everyone agrees Congress must pass a new tax law. If it does not, taxes on nearly everyone will soar under an absurd plan enacted in 2001 called the snap-back tax, which provides that in 2011 the tax law that had been in effect in 2000 will reappear. That would drive tax rates up sharply for most people, which might reduce budget deficits. But it is hardly what anyone wants if the economy is not booming by then.
Most of the tax changes being mulled can await Congressional action until next year. Under the snap-back tax plan, however, the estate tax is set to vanish for a year if nothing happens before the end of 2009, just over four months from now. Heirs of a very rich person who died on Dec. 31, 2010, would get everything, without any estate tax. If that person died a day later, his or her estate would owe 55 percent of everything over $1 million. (I call that the Dr. Kevorkian provision, after the physician who specialized in assisted suicides until he was sent to prison.) How will hospitals respond if heirs demand that life support be ended before the clock strikes 12?
It would have been nice to fix that up in a nonelection year, but the health care debate has consumed Congress. The chairman of one tax-writing committee, Senator Max Baucus, is still trying to shape a bipartisan health care bill, a Sisyphean task that may not leave much time for taxes. The other chairman, Representative Charles Rangel, has just discovered that he forgot to mention a checking account with more than $250,000 in it when he listed his assets. Tax policy may not be on the top of his to-do list either, at least while the dual investigations of his ethics are continuing.
The country got into the current tax mess because George W. Bush wanted it all in 2001. He could overcome procedural hurdles in the Senate and make the 10-year cost of his tax cut appear lower, if the entire bill was labeled temporary. So it was. To make things worse, that bill did nothing about the alternative minimum tax, which was supposed to catch wealthy citizens with big deductions and force them to pay something. By not lowering the A.M.T. rates when ordinary tax rates were cut, the law negated the cuts for millions of middle-class people. Now Congress passes a temporary fix every year to keep that from happening. President Obama wants to make that fix permanent, something Mr. Bush was hesitant to do because it would have made deficit forecasts look worse.
When Congress does get around to tax law, the political calculations could be fun to watch. Read the numbers one way, and President Obama’s proposals call for big increases in taxes on every group. Read them another way, they call for tax cuts for every group except the most prosperous one-tenth of 1 percent of Americans. Guess which interpretation the Republicans, and the Democrats, will choose.
The numbers to back each interpretation come from a new study by the Urban-Brookings Tax Policy Center, estimating effective federal tax rates using both current law and President Obama’s legislative proposals. The figures include all federal taxes, allocating corporate taxes to the owners of those companies and payroll taxes to the employees. Middle-income people tend to pay higher payroll taxes than the rich, because there is no Social Security tax on high incomes. The poorest are exempt from income tax, but do pay payroll taxes if they earn money.
In 2009, the average effective rate for all Americans is estimated to be 18.2 percent. The center estimates that if there are no changes in the law, that will rise to 23.4 percent in 2012. If the president’s proposals are all adopted, the figure that year will be 20.7 percent, with increases from 2009 for every group — those with the lowest incomes as well as those with the highest. How can that be, given that the president has promised to raise taxes only on those who make at least $250,000 a year?
Roberton Williams, a senior fellow at the Tax Policy Center, points to two reasons. First, Mr. Obama does not want to continue some special tax breaks, like a tax credit for new homeowners, that were part of the stimulus package he pushed through Congress. More important, the 2012 estimates assume a better economy, in which incomes will be higher and more people will therefore be in higher tax brackets. Mr. Williams argues that, eventually, President Obama’s vow not to raise taxes on the middle class is going to have to be violated. “There is just not enough money” earned by the very, very rich, Mr. Williams said.
When, or if, the government does confront the need for more revenue, Mr. Williams says he thinks it might adopt a value-added tax, which amounts to a national sales tax. Others urge energy taxes, to both bring in revenue and discourage energy consumption. Either would be political dynamite if there were not some sort of bipartisan agreement. Some countries, particularly in eastern Europe, went on enforced austerity this year because no one would lend them money.
In the United States, with its dollar printing presses, we assume that could never happen. But it is conceivable that someday investors will grow cautious about lending to a country with so little self-control and demand higher interest rates to protect them from the possibility of a depreciating dollar. Or they might insist on lending in euros or Chinese renminbi, currencies the American government cannot print.
Before the United States gets serious about raising taxes, I suspect that inflation will start to seem much more attractive, even if few are willing to say so publicly. In the past, inflation has enabled the United States to reduce the burden of repaying existing debt, and China, for one, has voiced fears we will do it again. Widespread inflation could also make depreciated assets — like homes — worth more dollars than the owner now owes.
Ben Bernanke got a second term as Fed chairman this week, something he earned for his evident success in dealing with the financial crisis. (He failed to see the crisis coming, but few others who might have gotten the job could claim a more prescient record.) In this term, he may find that inflation-fighting is not the road to popularity. His reappointment should serve as a reminder that things could be much worse. Which would you rather worry about: the specter of Great Depression II, which seemed so real only six months ago, or the possibility of excessive budget deficits in the next decade?
Reluctance to Spend May Be Legacy of the Recession
Even as evidence mounts that the Great Recession has finally released its chokehold on the American economy, experts worry that the recovery may be weak, stymied by consumers’ reluctance to spend. Given that consumer spending has in recent years accounted for 70 percent of the nation’s economic activity, a marginal shrinking could significantly depress demand for goods and services, discouraging businesses from hiring more workers.
Millions of Americans spent years tapping credit cards, stock portfolios and once-rising home values to spend in excess of their incomes and now lack the wherewithal to carry on. Those who still have the means feel pressure to conserve, fearful about layoffs, the stock market and real estate prices. “We’re at an inflection point with respect to the American consumer,” said Mark Zandi, chief economist at Moody’s Economy .com, who correctly forecast a dip in spending heading into the recession, and who provided data supporting sustained weakness.
“Lower-income households can’t borrow, and higher-income households no longer feel wealthy,” Mr. Zandi added. “There’s still a lot of debt out there. It throws a pall over the potential for a strong recovery. The economy is going to struggle.”
In recent weeks, spending has risen slightly because of exuberant car buying, fueled by the cash-for-clunkers program. On Friday, the Commerce Department said spending rose 0.2 percent in July from the previous month. But most economists see this activity as short-lived, pointing out that incomes did not rise. Some suggest the recession has endured so long and spread pain so broadly that it has seeped into the culture, downgrading expectations, clouding assumptions about the future and eroding the impulse to buy.
The Great Depression imbued American life with an enduring spirit of thrift. The current recession has perhaps proven wrenching enough to alter consumer tastes, putting value in vogue. “It’s simply less fun pulling up to the stoplight in a Hummer than it used to be,” said Robert Barbera, chief economist at the research and trading firm ITG. “It’s a change in norms.”
Here in Austin, a laid-back city on the banks of the Colorado River, change is palpable. A decade ago, Heather Nelson gained a lucrative job in telecommunications and celebrated by buying a new Ford sport utility vehicle with leather seats and an expensive stereo system. Today, Ms. Nelson, 38, again has designs on a new vehicle, but this time she plans to buy a Toyota Prius, the fuel-efficient hybrid.
In December, Ms. Nelson was laid off from her six-figure job as a patent attorney at a local software firm. Self-assured, she exudes confidence she will land another high-paying position. But even if her spending power is restored, Ms. Nelson says her inclination to buy has been permanently diminished. Through nine months of joblessness, she has learned to forgo the impulse buys that used to provide momentary pleasure — $4 lattes at Starbucks, lip gloss, mints. She has found she can survive without the pedicures and chocolate martinis that once filled regular evenings at the spa.
Before punishing heat and drought turned much of central Texas brown, she subsisted primarily on vegetables harvested from her plot at a community garden, where only one oasis of flowers remains.
Once intent on buying a home, Ms. Nelson now feels security in remaining a renter, steering clear of the shark-infested waters of the mortgage industry. “I’m having to shift my dreams to accommodate the new realities,” she said. “Now, I have more of a bunker mentality. If you get hit hard enough, it lasts. This impact is going to last.”
For years, Americans have tapped stock portfolios and borrowed against homes to fill wardrobes with clothes, garages with cars and living rooms with furniture and electronics. But stock markets have proven volatile. Home values are sharply lower. Banks remain reluctant to lend in the aftermath of a global financial crisis. Households must increasingly depend upon paychecks to finance spending, a reality that seems likely to curb consumption: Unemployment stands at 9.4 percent and is expected to climb higher. Working hours have been slashed even for those with jobs. Economists subscribe to a so-called wealth effect: as households amass wealth, they tend to expand their spending over the following year, typically by 3 to 5 percent of the increase.
Between 2003 and 2007 — prime years of the housing boom — the net worth of an American household expanded to about $540,000, from about $400,000, according to an analysis of federal data by Moody’s Economy.com. Now, the wealth effect is working in reverse: by the first three months of this year, household net worth had dropped to $421,000. “Not only have people lost money, but they don’t expect as much appreciation in the money they have, and that should affect consumption,” said Andrew Tilton, an economist at Goldman Sachs. “This is a cultural shift going on. People will save more.”
As recently as the middle of 2007, Americans saved less than 2 percent of their income, according to the Bureau of Economic Analysis. In recent months, the rate has exceeded 4 percent. Austin has fared better than most cities during the recession. Increased government payrolls enabled by the state’s energy wealth have largely compensated for layoffs in construction and technology. Local unemployment reached 7.1 percent in June — well below the national average. Housing prices have mostly held. Yet even people with high incomes appear reluctant to spend.
“The only time you do a lot of business is when you throw a sale,” said Pat Bennett, a salesman at a Macy’s in north Austin. “You see very little impulse buying. They come in saying, ‘I need a pair of underwear,’ and they get it and leave. You don’t really see them saying, ‘Oh, I love the way that shirt looks, and I’m just going to get it.’ ” Mr. Bennett attributes frugality to a general uneasiness about the future. “Our parents had the Depression,” Mr. Bennett said. “This is like a mini-shock for the baby boomers after the go-go years.”
At a mall devoted to home furnishings, many storefronts were vacant, and survivors were draped in the banners of desperation: “Inventory Clearance,” “50% Off,” “It’s All On Sale.” But at the Natural Gardener — a lush assemblage of demonstration plots that sells seeds, plants and tools for organic gardening — business has never been better. Sales of vegetable plants swelled fivefold in March over past years. The company added a public address system and bleachers to accommodate hordes showing up for vegetable-growing classes.
Part of the embrace of gardening stems from concerns about the environment and food safety, says the company’s president, John Dromgoole. Momentum also reflects desire to save on food costs. “People are very interested in shoring up against losing their jobs,” he said.
Clients Flee Cerberus, Fallen Fund Titan
Investors in hedge funds run by Cerberus Capital Management LP, whose audacious multi-billion dollar bet on the U.S. auto industry went bust, are bolting for the door, clinching one of the highest-profile falls from grace of a superstar in the investment world. Clients are withdrawing more than $5.5 billion, or nearly 71% of the hedge fund assets, in response to big investment losses and their own need for cash, according to people familiar with the matter. "We have been surprised by this response," Cerberus chief Stephen Feinberg and co-founder William Richter wrote in a letter delivered to clients late Thursday.
The client exodus is a reversal of fortune for Mr. Feinberg and Cerberus. The New York investment firm emerged as one of the most successful private-equity and hedge-fund firms over the last decade -- an era when these vehicles for the rich used cheap money to snap up troubled companies and vowed that their financial wizardry would make their investors a fortune. But investments in those very assets -- particularly Chrysler LLC and GMAC LLC -- proved to be the Cerberus funds' undoing. Cerberus isn't alone in seeing assets flee and its once-lucrative business crumble. The firm's success and now its struggles mirror the bubble in so-called alternative investments over the past decade -- and the air that has since come out of it.
In the nine months ended June 30, investors withdrew about $300 billion from hedge funds, contributing to a sharp decline in an industry that had grown fourfold this decade, to a peak of almost $1.9 trillion in assets in 2007, according to Hedge Fund Research. Big-name funds run by Atticus Capital LP, Pequot Capital Management and Cantillon Capital Management, among others, are shutting down. The comedown is especially stark for Cerberus and Mr. Feinberg, whose disdain for publicity created an almost Howard Hughes aura around him. Investors flocked to Mr. Feinberg's funds, giving him capital to transform Cerberus into a private-equity firm that acquired large equity stakes in companies including the National and Alamo car-rental chains, Air Canada, and Blue Bird school buses.
Mr. Feinberg, who started his career at Drexel Burnham Lambert in the 1980s, recruited former Vice President Dan Quayle and former treasury secretary John Snow, plus several prominent former chief executives to the firm. A hunter who still drives a pickup truck, Mr. Feinberg touted his blue-collar view of the world. His Park Avenue office has displays of old guns and a small motorcycle. On his desk is a stuffed Cerberus, the mythical three-headed dog that guards the gates of Hades.
But it was Mr. Feinberg's two boldest bets made at the height of the credit boom -- his acquisitions of Chrysler and GMAC -- that turned him and his firm into the center of attention on Wall Street. He and other investors contributed $14 billion to do the deals, and demand was so great that Cerberus charged his co-investors rich fees to invest alongside it. The two investments were effectively wiped out when Chrysler declared bankruptcy and GMAC was bailed out with billions of dollars in government aid. As part of that deal, Cerberus was forced to give up control of the company.
Meanwhile, the main hedge fund run by the firm, called Cerberus Partners, lost 24.5% in 2008. It is up about 3% in 2009. Since December, Cerberus has faced a wave of withdrawal requests by investors spooked by the markets and Cerberus's own losses. Cerberus refused to return cash, saying that weak market conditions would mean low prices if it sold holdings. Responding to the clamor from its investors, Cerberus last month began a restructuring plan that opened a window for investors who wanted to leave the funds. Cerberus hoped it could persuade them to move their assets to a new fund with longer asset "lockups" but lower fees.
At the time, the Cerberus bosses expected to retain more than half the assets of the funds, known as Cerberus Partners, in the new vehicle. Mr. Feinberg has personally called Cerberus clients over the past two weeks to discuss his firm's plans to retool the Cerberus Partners hedge funds, according to investors in the funds. Investors that chose to stick with Cerberus expressed confidence in Mr. Feinberg's ability to make money, particularly in a distressed environment. Although the firm has had missteps lately, some of its best investments have been made during periods of economic weakness.
Besides the hedge-fund operation, Cerberus runs private-equity and commercial lending businesses, which total about $16 billion in assets. Private-equity investors commit their money for long periods, so Cerberus's funds aren't suffering withdrawals. The hedge fund business has almost $8 billion, a third of the firm's assets. But most investors, known as limited partners or LPs, took the opportunity to leave Cerberus. Mr. Feinberg blamed the mass outflows on "the liquidity crisis" and the inability of cash-strapped investors to tie up their money in funds. A Cerberus spokesman declined to comment Friday beyond the letter.
"Unfortunately a number of our LPs have indicated that they cannot invest in Cerberus Partners II LP without quarterly liquidity," Mr. Feinberg wrote in the most recent letter. "In our view, given the current general illiquidity in the distressed markets, it would be practically impossible for a distressed investment fund to provide quarterly liquidity for 100% of its capital." Investors still support Cerberus's investment strategy and its long-term performance, Mr. Feinberg wrote. Nevertheless, many Cerberus investors chose to leave the fund, placing their money in a wind-down vehicle that will exit from its hard-to-sell assets over time.
Cerberus owns controlling stakes in some of its hedge-fund holdings, which make the stakes more difficult to sell. The fund holds a number of illiquid stakes in private companies, including a television station company Four Points Media Group and Albertson's grocery stores. Cerberus will charge investors a 0.5% annual management fee for the wind-down vehicle, a fee that was added in the last week. That amounts to nearly $28 million per year at the current asset level.
Cerberus said it still reserves the right to scrap the liquidation and restructuring plan. The firm could freeze withdrawals for another year and hope investors decide to stay put once the redemption gates open after that. But one investor doubted Friday that Mr. Feinberg would want to risk angering investors by doing that, especially after so many have asked for cash already.
Vulture Funds Descend on Banks
by Elizabeth MacDonald
Known on Wall Street as the “smart money” crowd that turned quickly dumb due to bad bets during the bubble years, the private equity crowd is now pushing to buy troubled banks, posing new problems for government banking officials whose banking oversight has not been so state of the art. The Federal Deposit Insurance Corp. is meeting today to decide whether to open the door wider to private equity firms hungering after buying distressed banks.
Would the descent of the vulture fund crowd in the damaged banking system pose a new systemic risk, at a time when the US government is desperately battling to stop any future dangers given the costly Chernobyl-like meltdown in the banking sector, and the US economy? At a time when the US government is still struggling with a bailout of the banking sector which has not been so cinematically picture perfect? The vulture funds coming to roost in the troubled banking sector comes at a time when the Federal Reserve is now being asked to take on extraordinary new ‘systemic risk’ regulatory powers that would let it wind down lethally large companies.
No bank regulator had such powers before over large companies such as AIG, Bear Stearns and Lehman Bros.
At the same time, the Federal Deposit Insurance Corp. has 305 problem banks on its radar screen which either need bailouts or are potential insolvencies, with few buyers in sight. Pension funds, which the FDIC courted to help, including funds in Texas and California, have yet to step up to the plate, and powerhouse banks like Bank of America and JPMorgan Chase are already struggling with digesting their purchases of Countrywide Financial and Merrill Lynch, and Washington Mutual and Bear Stearns, respectively.
At the same time, 105 banks have failed since the crisis began, depleting the FDIC deposit insurance fund to a record low of just $13 bn, as banks have not paid into the fund for about ten years when times were flush. The idea now is to let private equity firms buy banks by relaxing federal restrictions preventing outside investors from owning more than 24.9% of a deposit-taking bank. The thing is, for bankers, the private equity crowd is already here (see below).
And FDIC officials have noted that the private-equity crowd was on the scene during the S&L crisis of the late ‘80s and early 90s buying failed thrifts, including Bank of New England and CrossLand Federal Savings Bank.
Just as several vulture funds circled to buy Lehman's money management arm, Neuberger Berman, when the Wall Street investment bank collapsed in the fall of 2008. Neuberger Berman was eventually taken private in a management buyout last May.
Private Equity Firms Lobby Bank Regulators
However, the vulture funds want all the access to deposit without the onerous banking regulation rules. The likes of Henry Kravis, Steve Schwarzman and J. Christopher Flowers also don't want bank regulators crawling through their financial operations, so the business model here is to 'silo' the bank into a separate holding tank with its own operations. How far will private-equity firms push back on being regulated like bank holding companies? And wouldn't any push back come at the worst possible time for the US taxpayer, which has already ponied up mightily in the government bailouts? Already the private equity firms are lobbying hard to get the government to relax the ownership restrictions limiting outside stakes to a maximum 24.9% in a deposit bank.
And the private equity firms are balking at stiffer capitalization rules they may face, the ratio of a bank's capital which acts as a cushion to its assets. Bank regulators are considering a ratio of 15% for three years, nearly double the roughly 8% tier one capital ratio required under the Basel accords. Already, the FDIC is being pressured to drop that ratio back to 10%, or to what banks face now, 8%. The FDIC is also facing pressure to cut back on its cross-guarantee provision, which would lte the FDIC use the assets of a healthy bank owned by a private-equity firm to guarantee losses at other banks the firm may own, a backstop that would be pro-rated based on the firm's level of investment.
If the FDIC eases up on the rules, will vulture funds then descend on banks to use deposits to buy and flip other companies for profit? And if their market bets sour, will vulture funds then try to get at taxpayer bailout money through their banks? Will private equity owners then more aggressively, via their banks, choose own bank regulator, as banks are already doing now? Worth noting is that the US taxpayer has already bailed out a big private equity firm--Cerberus Capital Management, a co-owner of the troubled automaker Chrysler Corp. Federal Reserve Chairman Ben S. Bernanke is asking for rules for investments in banks so private investors can’t take advantage of U.S. assistance. But will that be enough to protect taxpayers, who have done more than their fair share in bailing out the financial system?
Here Come the Vulture Funds
The vulture fund crowd has had a dicey track record lately. It has made some bad investments during the bubble years, overpaying on the order of tens of billions of dollars to buy or invest in companies such as Hilton Hotels, First Data, Freescale Semiconductor, United Rentals, and Alliance Data Systems. Their modus operandi is typically to asset strip them, lever them up and then take the companies private in what’s known as a ‘leveraged buyout.’
Their business model took a shot during the recent credit crackup, as institutional investors demanded steeper yields on highly leveraged companies' debt.
That helped caused deal volume to dry up and profits to get hurt at private equity companies like Steven Schwarzman’s Blackstone Group and Henry Kravis’s Kohlberg Kravis & Roberts. Private equity firms are now sitting on tens of billions of dollars of investments in a number of heavily leveraged buyouts, including Harrah's Entertainment, Univision and Clear Channel Communications. So what better way to burnish a battered portfolio then by buying a distressed bank with a solid deposit-taking footprint?
The Vulture Funds Descending
IndyMac – The Pasadena, Calif. bank was bought out with $13.9 bn in rescue funds from seven private equity firms, including JC Flowers, Dune Capital (both run by ex-Goldman Sachs executives). Federal regulators had to look to private-equity buyers for IndyMac.
Other investors include a fund controlled by billionaire George Soros' Fund Management; Paulson & Co., which made hefty profits buying distressed home loans; Dell Inc. founder Michael Dell's investment firm, MSD Capital; Stone Point Capital; and a fund controlled by Silar Advisors. Watch this neat end-run likely to be aped by other players--because each of the firms are pitching in some money, no one firm owns more than 10% of IndyMac, thus circumventing the 24.9% federal ownership limit.;
First National Bank of Cainsville - LBO investor J. Christopher Flowers bought this Missouri bank himself, which poses an unusual conundrum for regulators. Flowers reportedly saw the Cainsville acquisition as a way to get a foothold into the banking business and make it easier to buy other banks. Flowers reportedly overhauled the board of directors and informed the Office of the Comptroller of the Currency of his plan to make more acquisitions—including possibly other lenders. Question for regulators: Is an individual person a bank holding-company? Can Flowers’ individual ownership then circumvent regulations in any way?
BankUnited Financial – took in investments from Blackstone Group and WL Ross, led by famed vulture investor Wilbur Ross; National City - Corsair Capital, which did nicely on its investment in National City; Washington Mutual - TPG (Texas Pacific Group) nearly lost all of its $7 bn in Washington Mutual, which went belly-up and was eventually bought at a fire sale price by JPMorgan Chase; PacWest Bancorp - CapGen Financial, a private equity firm run by former U.S. Comptroller of the Currency Eugene Ludwig, which invested $100 mn.
New high-yield bond indexes exclude bank debt
Bank of America-Merrill Lynch has launched new high-yield bond indexes to exclude bank debt, which has flooded the junk market this year and upset investors whose strategies focus mostly on industrial companies. The move by the leading provider of high-yield indexes came at the instigation of fund managers, who see bank debt as subject to political pressures more than to factors they typically analyze, such as debt ratios and cash flows.
"The index suddenly had the contamination of all these financials coming in and distorting the strategy," said Alex Vaskevitch, a manager at hedge fund LNG Capital. "We deal with corporate debt, not banks, because that involves political issues and other issues not in line with our strategy, so we wanted to clean it out of the index." Senior bonds from crisis-hit banks often continue to be ranked investment grade, but subordinated debt has frequently fallen to junk, particularly Tier 1 perpetual notes -- or hybrids -- which rank between debt and equity.
Banks can stop making payments on the debt without triggering default, and European countries have told a number of banks they rescued with taxpayer money to do so, introducing hard-to-predict policy risk into the market. Before the wave of bank debt, the European junk bond market consisted mostly of industrial and service companies such as Norske Skog, HeidelbergCement or TUI AG, whose bonds require an analysis of fundamental and financial factors.
"For us, the European corporate credits are a more accurate picture of what high-yield is," said Peter Aspbury, head of high-yield research for European Credit Management. Royal Bank of Scotland, Commerzbank and Bank of Ireland are all examples of bailed-out banks, whose senior debt is still rated investment grade but whose lower-ranking paper is now junk.
Financial debt had swollen to around 14.4 percent of Banc of America-Merrill's global high-yield bond index as of Aug. 21 from around 2 percent in early 2007. In Europe, the sector accounts for more than 24 percent of the euro bond index and almost 59 percent of the sterling index. "We have released many indices over the past half-year to year that exclude various segments of the financial sector," said Phil Galdi, managing director of global bond indices at Banc of America Securities-Merrill Lynch.
Junk bond managers who ignored junk-rated bank debt over the past six months are likely to have underperformed the main index as Tier 1 prices have rebounded to between 30 and 50 cents on the euro from lows below 10 cents in March. "I can imagine there will be plenty of high-yield fund managers crying into their bonus pots," said Philip Milburn, a fund manager at Aegon Asset Management. "Our mandate from clients is to get as good a return as possible from anything that is rated high-yield," he said.
British fund firm Liontrust Asset Management began looking at subordinated bank notes in February and March. "We had to do an enormous amount of work on it," said Paul Owens, head of fixed income research. Owens pored over 250-page regulatory filings to evaluate bank finances as well as 300-page prospectuses from five and six years ago to sort out complex legal language determining whether a security was more or less likely to be repaid.
He reviewed historical precedents including Continental Illinois, the U.S. savings-and-loan crisis and Sweden's banking crisis for clues on what regulators were likely to do. "You had to figure they were reading the same documents we were." The resulting Tier 1 investments "have been very good to us", Owens said. "If you do that homework, you can get handsomely paid for it." He added, however, that the firm will probably not have Tier 1 in its portfolios a year from now. ECM, meanwhile, manages subordinated bank debt separately from its non-financial high-yield exposure. "We consider it to be its own asset class, and where we do buy it, it is for diversified funds where we have a remit to invest in virtually any asset class considered to be European credit," Aspbury said.
Pensioners 'stay in bed' to cut fuel bills
Older people are being forced to cut down on their energy usage as they face soaring fuel bills. Pensioners have seen their gas bills jump by 55pc in the two years to April 2007, while electricity bills have risen by 36pc, according to the Institute for Fiscal Studies. As a result, the amount of money older households spend on fuel has increased by about 22pc during the same period, despite them cutting down their consumption by 10pc.
Age Concern and Help the Aged, which commissioned the report, warned that further price rises seen during 2008 would have increased the pressure on older people, forcing many of them to turn down the heating or cut spending in other areas in order to afford their energy bills. The group said some pensioners were even resorting to staying in bed in a bid to reduce the amount they spent on heating. The research also uncovered very different lifestyles being led by the poorest and richest pensioners.
In 2007, the poorest fifth of pensioners spent nearly 40pc of their budget after housing costs on food and fuel, while the richest fifth spent just under 20pc of their income on these things. Instead the single biggest area of expenditure for the richest group of pensioners was holidays, at 12.5pc, while the poorest fifth spent only 3.3pc of their budget on trips away, nearly half the 6.5pc and 6.2pc of their income that was devoted electricity and meat respectively. Pensioners have also seen an increasingly large proportion of their budget taken up by local taxes, such as council tax, with this soaring by 84pc between 1995 and 2007 to account for 7pc of total expenditure, compared with 4pc for non-retired households.
Older people are continuing to help out younger family members, with cash payments, presents to family and friends and charitable donations the 10th largest area of expenditure for the over 80s. Andrew Harrop, head of public policy at Age Concern and Help the Aged, said: "What's most clear from this important new research is the significant differences in living standards between older people at different ends of the income scale. "Shockingly, the report finds that while poorer pensioners are spending more of their available income on energy, they are - at the same time - reducing the amount of energy they buy.
"Not only does this demonstrate the problem of soaring energy costs in recent times, but is a warning to policy makers and others that vulnerable older people could be putting their health at risk in winter just to cut costs." Liberal Democrat work and pensions spokesman Steve Webb said: "Pensioners have been hit by soaring fuel bills which have taken a growing chunk out of their meagre state pensions. "Once again, we see the woeful inadequacy of the basic state pension, one of the worst in Europe. "Forcing pensioners to rely on complex and poorly understood means-tested benefits is simply not the answer to pensioner poverty. It is time that the state pension was raised to a decent level.
"As a first step, the Government should restore the earnings link at once." Energy and Climate Change Minister David Kidney said: "Pensioners must not feel they can't heat their homes this winter. "Cuts in the wholesale costs of energy must be passed on by energy suppliers to consumers, and that's particularly important for those on lower incomes. "We're giving extra help to those households through a range of measures including Warm Front grants for insulation and heating improvements, winter fuel payments to all pensioners this winter, and we will create mandatory social price support for the poorest at the earliest opportunity."
The Grapes of Wrath revisited: The plight of Native Americans
Dollar Trading and Pawn has something for everyone on the move around Arizona's badlands. Polished leather saddles with fine decorative carvings are racked up at the door for about $500 apiece. They are popular with cowboys and those still widely referred to in Arizona as "the Indians". Lassos are strung up under the veranda.
Truckers hauling foreign car parts from California ports to American assembly lines pull off the highway outside Winslow to buy secondhand Citizens' Band radios and pawned electronics. Tourists pick up the local handmade trinkets, Native American dolls dressed in feathered headgear that no tribe in the region ever wore, and Navajo jewellery that says they've been to Arizona, even if only for a few hours largely spent on the interstate highway.
But the vast majority of regulars through Dollar's doors are Native Americans. Some are hawking homemade wool blankets from the sheep that graze the desert. But increasingly, as recession drives the local population on to part-time working or out of a job, they come to pawn the family possessions. "Business is booming, excellent," said Ben Hatch, Dollar's owner. "It's 90% Native Americans. They need a few more dollars to get by. People don't have the money they used to have."
Drive in any direction from the interstate highway and the asphalt increasingly gives way to washboard roads probing deep into the vast Native American reservations dotted with towns that don't feature on tourist maps. The reservations are a fraction of the land once overseen by the Navajo and smaller tribes but still stretch through thousands of square miles of northern Arizona and New Mexico. Here the worst economic crisis in seven decades is deepening a crisis of identity. Some tribal elders complain that the young are being lost to the American pursuit of the good life, or at least the means to make a living.
In the Great Depression of the 1930s, as John Steinbeck documented the plight of hundreds of thousands of the desperate and destitute making their way along the road that now runs past Hatch's pawnshop in search of an illusory dream of plenty in California, the suffering of Native Americans was virtually invisible to most of the US. Navajo struggling to get by today say that much has changed since their forebears were confined to reservations, even if something of the old attitudes live on in the tourist shops done up as tepees with redskin statues to hawk "Indian crafts".
But the plight of women such as Rita Watson Claude still remains largely unseen except by her fellow Navajo. She is standing a few yards off the main road to Tohatchi, a desolate Navajo town in northern New Mexico of little more than a thousand people living in dilapidated houses and trailers with wrecked cars piled out back and sheep grazing between the plots. A third of the population lives below the poverty line.
Spread across Claude's table are worn clothes, a handful of old DVDs, some utensils, an array of chipped plates.
Children's shirts and jeans that her 10-year-old son, AJ, has outgrown sit in a couple of boxes on the ground alongside the boy's PlayStation. Until a few weeks ago she had a well-paid job at an optician's in Gallup, a larger town next to the highway with a sizeable Native American population. But business has collapsed and Claude's hours were cut in half, leaving her unable to support an unemployed husband and three children. "We're just selling stuff. The economy's real bad. My hours were cut, and so this is the little thing I can do to make extra money," she said as the wind threw dust into her face and swept clothes from the table.
Cars pull over now and then. People browse. Someone asks how much for the PlayStation. Twenty dollars. No one buys. "I do sell stuff. It covers like food. Not even the bills, but it covers food," said Claude. "There's a lot of people like this. A lot of them are cutting back on their [working] hours." She looks at AJ and wonders if he'll still be a resident of the Navajo Nation in a few years: "The children are losing their identity. They want a better way of life. Everything's so modern. The phone's right there. The stove, you just turn it on. The heater you just turn it on and you have heat in the house. Back when I was growing up, we used to haul wood and chop wood. We hauled water. We never took showers every day."
Easier it may be than 30 years ago, but Navajo parents realise the tribe is losing many of its children to the economic aspirations shared by other Americans. "The culture's not strong no more. They're going toward the white people's way. He doesn't speak Navajo," she said, gesturing at AJ. One of Hatch's workers at Dollar Trading and Pawn tells the same story. Emma Yazzie is watching BBC America on a widescreen television someone has pawned. "My oldest son is fluent in Navajo, but my youngest doesn't know," she said. "Some of these kids lose their roots and lose their identity as they try to fit in with other cultures. It's up to the parents to show them where they come from, but we don't always do a good job. It's hard to tell them they can't have what other Americans have, like jobs."
Yazzie's job looks secure as the pawn business thrives, but her husband was laid off from his job as a carpenter in February. "I live on the Navajo reservation and drive 60 miles to work. We live out in the open. We have to haul water to the house in the pickup. Now I'm the only one working, it's kind of hard on us," she said. "I have two sons who are not working. My daughter just got a job as a veterinary assistant but it's across the state. It's worse for others. People, mostly Native Americans, bring in all kinds of things to pawn. Stereos, tools, sewing machines, jewellery. People are leaving the reservation to look for work. Going to the cities. The young people."
The newest and glitziest buildings on the reservations are mostly the casinos built to bring in tourist dollars, although in the middle of the afternoon in the Sky City casino in Acoma, New Mexico, it's mostly Native Americans and truckers playing the slot machines. Fifteen miles away, where the tourists rarely venture, at the headquarters of the small Pueblo tribe, Petruuche Gilbert is seething. The tribe's poorest members are confined to trailer homes. None of the houses shows signs of prosperity, although there is often a pickup truck in the drive. Many of the young choose to get out, especially single men who head to the cities in search of work.
"Our children are brainwashed," said Gilbert, the tribe's land commissioner. "The children are attracted by the promise of money and the American way of life. They turn their backs on where they come from. They're so brainwashed to believe in the principles of the United States they don't challenge it. They're deeply ingrained to be a colonised person and to behave just like the good old American citizen."
Gilbert is as angry at his own people as he is with the US government and white Americans.
He wants Native Americans to fight for their language, their culture and ultimately to try to overturn what he calls the colonisation: "We are prisoners living in occupied America. I really find it fascinating that you don't have real violent resistance here in the States that you do elsewhere off of colonised people. Indigenous peoples are the only ones that have this legitimate struggle to be violent against the United States because of this system of tyranny by the government against indigenous peoples, because by the laws of this land you are forced to behave in this manner."
He glumly acknowledges that there is unlikely to be armed resistance or an overturning of the US constitutional court rulings that affirmed the confiscation of Native American lands. Annie Johnson, a mother in her early 40s, certainly isn't listening. She is waiting outside a hall in Tohatchi for a $5 bingo game. "We tell our kids to get out of here. There's no work, no opportunities. My daughter has gone to study trade in Roswell. If she can find a job, she won't come back," she said, as her bingo partners nodded in agreement. "I don't think it matters that they can't speak Navajo. What good is it? Get out, get a job."
Iceland to pay back Icesave cash
The Icelandic parliament has voted in favour of repaying more than $5bn (£3bn) to the governments of the UK and the Netherlands. The so-called Icesave bill will reimburse funds paid by the governments to compensate those who lost money in the Icelandic online bank Icesave. About 400,000 savers lost their money when its owner Landsbanki collapsed last year. The bill has enraged many in Iceland, who fear it might bankrupt the nation. The deal was agreed in June, but was only passed after an amendment was added setting various limits to the payments.
The Icesave bill's passage means that the Icelandic government has agreed to guarantee the repayment of the £2.3bn loan the UK government made last year to ensure that none of its savers lost money. The amendments will now have to be agreed by the UK and the Netherlands. "It is my sincere hope after this vote, that the UK and Holland will show us understanding and fairness in this matter," Iceland's Prime Minister Johanna Sigurdardottir said after the vote in parliament. The amount that will be paid is limited based on the level of Iceland's economic output, or gross domestic product (GDP).
The country will have to pay up to 4% of its GDP each year to the UK and 2% to the Netherlands. No payments will be made for the next seven years, but the bill says that if the full payments have not been made by 2024 then no further payments will be made. Effectively, there is only an eight year window for the loans to be repaid.
The amendments to the bill were added by MPs to try to soften the impact of the legislation. Some members of parliament have questioned why the government should be repaying the debts of a private bank. In the vote, 34 members voted in favour, 14 voted against and there were 14 abstentions. There is particular anger at the UK for using anti-terror laws to freeze Icelandic banking assets in the UK when the crisis began last year. Chancellor Alistair Darling was also accused of undermining confidence in the Icelandic banks. Iceland eventually had to take over its three biggest banks - Glitnir, Kaupthing and Landsbanki, which owned Icesave.
In a statement, the UK Treasury said, "As you would expect, the UK will look carefully at any conditions placed upon the loan to ensure that they are reasonable". Iceland hopes that the agreement to make payments to the UK and the Netherlands will help it to get more financial aid. It does not cover the money councils invested in Icelandic banks. They are engaged in a separate process to recover their money, led by the Local Government Association. As part of that process Nottingham City Council, which lost £42m, received a first payment on Friday of £2.5m.
Natural Gas Threatens To Overflow Storage
A burgeoning glut in U.S. natural gas supplies is moving into uncharted territory. By fall, the U.S. might find out just how much it can--and can't--store, which could depress already low prices of $3 per 1,000 cubic feet. The brim is believed to be just under 4 trillion cubic feet in the Lower 48 states, but, "We don't really know for sure because we have never been here before," says Carl Kirst, an energy analyst at BMO Capital Markets.
The Energy Information Administration reported on Thursday that the amount of so-called "working gas"--the amount that can be used from storage--hit 3.258 trillion cubic feet last week, the highest on record for August, enough to meet about 54 days of average consumption in the U.S., far more than needed in summertime. One would think that the natural gas bulge would lead to a stampede of storage construction projects, and good times for storage companies like Niska Gas Storage of Calgary, Richmond, Va.-based Dominion Resources and Falcon Gas Storage of Houston, but the picture is complicated by the freeze up of financing, the prevalence of long-term storage contracts and federally regulated storage rates.
There has been a push to build more storage since hurricanes Katrina and Rita hit in 2005, along with expectations of growing liquefied natural gas imports. Jeff Wright, director of office of energy projects at the Federal Energy Regulatory Commission, says approved applications for new gas storage facilities averaged about 30 billion cubic feet a year between 2000 and 2004. It nearly hit 100 in 2005. In 2008, the commission approved 216 Bcf of storage, he says, attributing the jump to the development of unconventional shale plays and expectations of LNG imports. "We should easily get to triple digits again this year," Wright says.
But while projects are certified, many are being canceled or delayed because of higher costs, a tightening in lending and lack of market interest, analysts say. "Here in Houston, I used to joke that you couldn't throw a rock without hitting private equity involved in building new storage," says BMO's Kirst. "The pace has slowed down dramatically."
Why? The business is not for the "faint hearted," says Rick Smead, a director of energy analysis at Navigant Consulting. "You are basically building a 50-year investment based on what you saw over the last year. And once you have this capacity in place, by itself that tends to start dampening out some of the volatility, so the very thing that drove its economics may not be there to the same extent once the facility is in place. It's just a big juggling act."
On Tuesday, Niska, which says it's the largest independent natural gas storage company in North America, announced that it finished a 10.5 billion cubic foot expansion. Canada's storage capacity is also nearly full and analysts expect some of its natural gas to flood into the U.S. market. Falcon's MoBay Gas Storage Hub in Mobile Bay, Ala., is the largest storage project FERC approved since 2000. MoBay was approved to hold 50 billion cubic feet of gas in 2006. But it isn't expected to open until 2011. Falcon declined to comment about the current market.
Sempra Energy reported in its second-quarter earnings that one of its subsidiaries wrote off $64 million from a natural gas storage project near Lake Charles, La., called Liberty Gas Storage. It was certified in June then canceled due to "subsurface and well-completion problems," Sempra says. For the short term, there are reports that there will be another 100 billion cubic feet of space available in 2009 than previously expected. Teri Viswanath, director of commodities research at Credit Suisse in Houston, recently estimated there is 86 Bcf more.
It doesn't matter, says Viswanath. At least for now, "It's not enough. We've never had a situation in U.S. history where supply has so grossly outpaced demand." Natural gas inventories operate on a seasonal trend. During warm, low-use months, gas is injected into salt domes and depleted gas fields, then withdrawn when temperatures cool. With two months left in the time typically used to build up stocks, the pace is far ahead of normal. The finite constraints of storage could force cutbacks in production.
Like many oil and gas companies, EOG Resources of Houston expects to increase production this year, in its case by 5.5%. But Chief Executive Mark Papa said earlier this month during a second-quarter earnings call, "I will caution investors that this assumes we don't curtail any North American gas [production] in the second half because of market storage issues."
"It's obviously going to be real close as to whether we have storage and do shut-ins or not," he added. "My own opinion is we're probably going to get to about 3.9 [trillion cubic feet] in storage and the question is do we really have 3.9 Tcf of storage out there." He said full storage could force production to slow down as more backpressure on wells builds up across the country. "That may just cause an automatic curtailment pretty much across the board."