New York City, Pier in Brooklyn, view to Manhattan over East River
Ilargi: Bear is bull and bull is bear; hover through the fog and filthy air.
Shakespeare, Macbeth, sort of like
There's a theory that one way to tell when a market rally may end is to look at how many pessimists have turned optimist (it works in reverse as well). At the rally’s peak, many will have turned that would never be expected to. Investor Jim Grant is seen as a real bear, and he's just turned bullish. Does that mean the really is over? Well, it's not that simple of course, it's just a theory after all, but it's getting interesting. And there's no doubt that markets often turn when just about everyone has started donning a party-hat first thing in the morning. The larger the herd is, the more it behaves like one.
Michael Panzner says this about Jim Grant's "rebirth", which sums up my reservations as well:
Jim Grant: Ringing the Bell at the Top?
- Aside from discounting the fact that there are aspects to the current unraveling that are historically unique and extraordinarily unsettling (e.g., total credit market debt relative to gross domestic product is well beyond anything this country has ever witnessed), Mr. Grant makes a number of curious assertions.
For one thing, he assumes that the current downturn is near its nadir, instead of a temporary floor built on a massive stimulus injection and a knee-jerk bout of inventory restocking. Among logicians, such an analytical approach might be described as "begging the question."
As you may have gathered by now, I’m way behind the curve on this one. I’m even still trying to figure out what on earth there is to be bullish about. Now, there is of course little or nothing rational about herd behavior. But those inside the herd will try to rationalize their way into their new-found position regardless, so let's see if we can reason ourselves into some sense of it all.
I think the main fault in the "bullpen" may be the assumption that a stock market rally somehow also means a recovery in the real economy. If such a recovery is not forthcoming, many would agree, a rally will necessarily be shortlived. So, once again, let's focus on that real economy, since that is where the key is, not in the stock markets, which can remain disconnected from it only for so long.
The main drivers of the real economy are consumers. They are running out of credit, and they are cutting their spending. Then again, some will argue that they can change their attitudes rapidly if circumstances warrant it. At this point in time, I would argue that the best indicators of the state of the economy are banks and houses. Please allow me to explain why and how.
We are moving towards a society where everybody owns an interest in everybody else's home through the government, interests that are moved through an opaque system of ever-changing agencies and semi-private enterprises that just about nobody to date has been asking any serious questions about. The myth of the grandeurs and benefits of home-ownership has been sold and advertised so well that by the time people figure out what a scheme it is, it will be too late.
Ask yourself this: if everybody owns a piece of all homes, wouldn’t it be easier if they all just owned their own? There is one difference only, isn't there? In the present system, lenders, banks, middlemen, whatever you call them, get to rake in fees, commissions and interest rates, in essence simply for being redundant. And if home prices rise, it's the banks that profit, not the buyers. So they’re not only redundant, there's much more going on. And that's where the government comes in.
The only way the scheme has been able to continue until now is through wide-spread government interference that guarantees elevated real estate prices. And the citizens have believed for decades that this is in their best interest, a scheme, supported by their own government, that guarantees that they can buy a home only at many times its real value. It is not, and never has been. And it's falling apart, fast. That is a good thing, even though it will hurt like hell.
U.S. "option" mortgages to explode, officials warn
- The federal government and states are girding themselves for the next foreclosure crisis in the country's housing downturn: payment option adjustable rate mortgages that are beginning to reset. "Payment option ARMs are about to explode," Iowa Attorney General Tom Miller said [..] "That's the next round of potential foreclosures in our country" [..]
- Option-ARMs are now considered among the riskiest offered during the recent housing boom and have left many borrowers owing more than their homes are worth. These "underwater" mortgages have been a driving force behind rising defaults and mounting foreclosures.
- In Arizona, 128,000 of those mortgages will reset over the the next year and many have started to adjust this month, the state's attorney general, Terry Goddard, told Reuters after the meeting. "It's the other shoe," he said. "I can't say it's waiting to drop. It's dropping now."
Still, before the final curtain, much more blood and water will flow under all of America's bridges. People used to lavish sums of money for nothing are not known for easily giving up their golden geese. As Fannie Mae and Freddie Mac have become over-indebted liabilities, understudies Ginnie Mae and the FHA have come to fill in as the protagonists. The FHA announced last week that its reserves are now below 2% of its obligations. In other words, another government agency leveraged over 50:1. And another inevitable candidate for a bail-out.
The Bill Comes Due, Vexing Housing and Banking Agencies
- A year ago, as the financial system was threatening to collapse, federal regulators offered all sorts of assistance to ward off catastrophe. The strategy worked, at least so far, but the bill is starting to come due. The Federal Housing Administration, which is supporting the housing market by insuring loans for millions of struggling buyers, said Friday that its cash reserves had fallen below 2 percent for the first time. Raising its insurance premiums would replenish the reserves, but could also hamper the housing recovery. Another unpleasant option: asking for a federal bailout.
I don't see a way to stop this, wrong as it may be. The government -yes, that means you- has trillions of dollars at stake in the real estate market, and it looks like it's just getting started, it’s now in 90% of the new loans. Which makes me think of what Meredith Whitney said 10 days ago:
Home Prices Could Fall by Another 25%
- Home prices in the US could fall by another 25 percent because of high unemployment and another leg down will come for stocks, banking analyst Meredith Whitney told CNBC Thursday.
- "No bank underwrote a loan with 10 percent unemployment on the horizon," [..] "I think there is no doubt that home prices will go down dramatically from here, it's just a question of when." Local governments and states are chronically under-funded and "most states are under water," adding to the problem of low private consumption [..]
- "If you look at the drivers for unemployment I don't see that reversing very soon," Whitney said. If consumers were to decide to spend, "that would be a game-changer, but it would be an unnatural thing to do in a recession. A lot of themes are constant, which is the US consumer and the small business don't have any credit, credit is still contracting,"
Now, I have long said that home prices will fall 80% or more, but that, even after the 30%+ drop we've already seen as per Case/Shiller, still remains too much of a left field fly-ball for most. Perhaps they'll listen to Meredith?
Thing is, no matter who you do or don't listen to, if domestic real estate prices do plunge 25% more, it’s sort of all bets are off. For that would -make that will- break a million straws on a million camels’ backs. All the public funding, through direct subsidies and indirect guarantees, hasn't been able to halt the downfall until today. With a widely acknowledged pattern of millions more foreclosures and millions more unemployables, the chance of halting it approaches zero. Which means the government, -and again, that means you- is set for trillions of dollars in additional losses.
It means millions more foreclosures. It means as many as 75% of mortgagees will be underwater on their loans. Hence this headline:
It means a situation that can no longer be "solved" by trying to hide our sore and battered lives and asses from reality. It means Jim Grant and his newfangled bully buddies are painfully wrong. It also means that hundreds of banks that acted as lenders are beyond salvation. Which brings us to the FDIC, which, it just so happens, is set to prove everyone wrong who's claimed it was bankrupt, by drawing on either of two direct lines with the Treasury, one for $100 billion, another for $500 billion. There is a problem here though: the Treasury doesn't have that kind of money. It will have to borrow it from you. You who are already about to lose trillions through the government mortgage guarantee schemes.
There's another problem too: the FDIC closed two small banks on Friday, while an unofficial Problem Bank List which Calculated Risk publishes, added 17 banks last week, and removed 5, 3 through failure. The 436 banks presently on the list have $294 billion in assets. The FDIC has less than $10 billion to insure those assets, and the trillions more in deposits in the hands of banks which are not yet, but soon will be, "challenged".
In the end, you'll wind up paying for the costs of insuring your own deposits. Deposits which don't even exist anymore other than in a digital database that can be wiped clean in microseconds; your bank gambled them away in search of profits and bonuses.
One such bank, one of the most troubled and one of the biggest at the same time, is Wells Fargo. The perfect, albeit not exactly shining, example of what is going on and going wrong. Or, more accurately, what went so wrong in the past that the consequences can no longer be hidden in the present.
Wells Fargo’s Commercial Portfolio is a Ticking Time Bomb
- [..] the bank has hired help from outside experts to pour over the books… and they are shocked with what they are seeing. Not only do the bank’s outstanding commercial loans collectively exceed the property values to which they are attached, but derivative trades leftover from its acquisition of Wachovia are creating another set of problems for the already beleaguered San Francisco-based megabank, Wachovia, which Wells purchased last fall as it teetered on the brink of collapse, was so desperate to increase revenue in the last few years of its existence that it underwrote loans with shoddy standards and paid off traders to take them off their books.
- [..] Wachovia promised to pay the buyer’s risk premium by writing credit default swap contracts against these subordinate bonds.
- [..] The real question is, however, was enough disclosed to investors about this practice when Wells purchased Wachovia? One top hedge fund manager who has experience in outing accounting fraud told Bank-Implode "They needed to estimate that CDS liability upon the purchase of Wachovia. If they didn’t, they’ve committed fraud."
The author then makes a weird mistake, one that is becoming common, Richard Mogambo Daughty did it too. That doesn't make it any less ugly and potentially damaging to one's credibility, though.
- [..] Harry Markopolos, the whistleblower on Bernie Madoff, gave a speech this summer at the Greek Orthodox Church in Southampton predicting more major scandals will soon be revealed about the unregulated, $600 trillion, credit default swap market. Ouch!
There are "only" some $60 trillion in CDS. The $600 trillion is more likely to represent all remaining outstanding derivatives. A 90% mistake? Ouch, indeed.
- [..] Wachovia’s third quarter 2008 filings, which reflect their assets three days before Wells Fargo agreed to the acquisition, shows the bank held a whopping $230 billion in its commercial loan portfolio.
- [..] [Wells Fargo’s] Construction and Development portfolio, with $38.2 billion in loans, is defaulting at a level eight times greater than the rest of the nation’s banks
- According to Meredith Whitney, founder and CEO of Meredith Whiney Advisory Group, Wells is working an accounting game of "extend and pretend." "If the bank doesn’t change a maturity date, then it does not have to take an impairment charge on its books, which would affect earnings," says Whitney. If the loans don’t look like they are impaired, the rating agencies then do not have to downgrade the billions of CMBS that Wachovia sold to other banks and investors.
- Adds Whitney "We’ve seen Wells Fargo play modification games with its own loans. Why wouldn’t they do it with the loans they took on from Wachovia?"
And there's more on Wells Fargo, none of it very pleasant.
Bove: Wells Fargo Sitting On A Volcano About To Explode
- Richard Bove says the gap between management views of the company and shareholders may be growing and he outlines a set of reasons that could lead one to believe Wells is either delusional or trying to do its best to postpone the inevitable.
- The most troublesome point is the bank’s "questionable" loans and securities, which seem like a ticking time bomb. Bove says that outsiders are convinced that the bank is understating its loan problems in the home equity, commercial real estate, and credit card arenas. Bove adds that there are significant issues being raised concerning the bank’s valuation techniques in its derivatives portfolio and its accounting in these areas.There is constant argumentation over the bank’s methodologies in valuing its mortgage servicing portfolio. Additionally, a number of state attorney generals are unhappy with certain of the bank’s mortgage sales practices.
- Then, regarding the bank’s balance sheet, he says that Wells may be forced by the imposition of Basel II accounting rules to add hundreds of billions in assets to it [..]
These problems could make Wells Fargo a giant headache for the FDIC, unless the Treasury itself jumps in with a bail-out.
Wells Fargo's total assets? $1.284 trillion. Yours to guarantee, swallow, take your pick. Wells is WAY too big to fail. It's also WAY too big to survive on its own. Bail-out it is.
You ever think there's any chance guys like Jim Grant change teams just because it all looks so much easier from that side of the turf? Extend and pretend till nature calls?
Oh, before I forget: There's also a whole bunch of major US companies about to go bellytittling upwards. No more Sprint calls, no more AMD (go all the way, Intel!!), Goodyear (make that "not"), and what have Macy's and CBS ever done for you anyway? Don’t think of them as losses. Think positive.
There’s a world full of opportunities out there. And boy, is it ever broke.
Audit Integrity Announces Results of Corporate Bankruptcy Study; Identifies Companies Most Likely to Declare Bankruptcy
In response to amplified concern in the market for risk related to corporate insolvency, Audit Integrity, an independent financial research and risk modeling firm, today released the results of its bankruptcy model research and has identified 20 corporations, with $1 billion or more in market capitalization, that have the highest probability of declaring bankruptcy in the next twelve months.
According to the U.S. Bankruptcy Courts, the number of business bankruptcy filings during the first six months of the year rose 64 percent over the first half results in 2008. With the increased incidence of company failures, corporate stakeholders such as insurance companies, auditing professionals, procurement executives and regulators, find corporate survival to be a critical risk issue.
Current approaches to determining bankruptcy risk generally fail to react quickly to changes to the economic environment, and do not factor in the potential for corporate fraud. By incorporating these risk factors into the Audit Integrity Business Risk Model, this new approach has been found to greatly improve the identification of companies at risk of bankruptcy. Against the most widely used bankruptcy model, the Altman Z-Score, the Audit Integrity bankruptcy Risk Model results have been more than 20 percentage points higher in predicting bankruptcy.
The results from Audit Integrity`s bankruptcy research indicate that the media and transportation industries are especially vulnerable. Of the over 2,500 U.S. corporations receiving bankruptcy risk scores from Audit Integrity, TV and Publishing companies were found to be over four times as risky as other companies, while automobile and airline industries were just slightly less risky.
The findings suggest that fraudulent accounting and poor governance impact bankruptcy risk in addition to more generally accepted factors such as measures of liquidity, leverage and profitability.
"Evidence shows that bankruptcy filings tend to lag after an economic downturn so its extremely important that investors and those concerned with the risks around corporate failure mitigate their exposure to companies likely to collapse," said Jack Zwingli, CEO of Audit Integrity. "Market volatility and sudden downturns such as we have been experiencing must be factored into bankruptcy risk. Fraud also plays a part, especially when companies are faced with survival decisions. These are the toughest companies to identify because, on paper, they appear solvent. Our model uncovers the underlying fraud that can be behind seemingly healthy financial statements."
Audit Integrity has identified the following companies that have the highest probability of declaring bankruptcy among publicly traded firms with more than $1 billion market capitalizations:
- Advanced Micro Devices, Inc.
- Amkor Technology, Inc.
- AMR Corporation
- Apartment Investment and Management Co.
- CBS Corporation
- Continental Airlines, Inc.
- Federal-Mogul Corporation
- Hertz Global Holdings, Inc.
- Interpublic Group of Companies, Inc.
- Las Vegas Sands Corp.
- Liberty Media Corporation (Capital)
- Macy's, Inc.
- Mylan Inc.
- Oshkosh Corporation
- Redwood Trust, Inc.
- Rite Aid Corporation
- Sirius XM Radio Inc.
- Sprint Nextel Corporation
- Textron Inc.
- The Goodyear Tire & Rubber Company
10 Big Companies That Are Veering Toward Bankruptcy
Despite a few green shoots in the economy and a rocketing stock market, many large companies are still struggling to avoid bankruptcy. A new report by Audit Integrity identifies some high-profile names "that have the highest probability of declaring bankruptcy among publicly traded firms."
Which companies appear the worst off? We took the list and removed any company with a market cap under $3 billion. We then ranked the remaining names by a simple measure of the market's perceived bankruptcy risk - Market Cap (MC) divided by Enterprise Value (EV). The less MC vs. EV, the less residual shareholders' value (above what debt holders can claim) the market is pricing-in for the company. Thus a lower MC/EV means the market thinks the company is more likely to go bankrupt.
When you have tons of debt financing your fleet of cars, falling rental demand really hurts. While the company raised new capital in May for some breathing room, Fitch and Moody’s actually cut their ratings for the company in July. Ignoring the downgrade, shares kept rallying and are now at over five times the March $2 low. Best of luck.
Market Cap (MC)/Enterprise Value (EV) = 32%
What a crappy time to be selling business jets. Textron wrote down $2.3 in its backlog this year after it cancelled a new jet design, and demand for its other aircraft-related offerings has plummeted. Shareholders may be heartened by the company’s ability to push back some debt maturities lately, but deteriorating credit quality at the company’s leasing arm makes the outlook uncertain at best.
Sprint Nextel is bleeding customers, and could lose as many as 4.4 million net post-paid subscribers this year. This is a huge problem when you have large amounts of maturing debt over the next few years. A recent Deutsche Telekom acquisition rumor offered some hope, but that appears to have faded. Facing a difficult road ahead on its own, the company better keep its lawyers on speed-dial.
Does anyone even shop at department stores anymore?Same store sales will likely keep falling at Macy’s right through 2009. With $2.4 billion of maturing debt over the next five years, the company is trying to cut costs, and has already reduced its dividend. Hopefully the US consumer will bounce back soon, and actually want to shop at Macy's.
In a classic case of management empire building, Mylan overpaid big time when it bought Merck’s generic business back in 2007 and is now stuck with $5 billion of long-term debt as a result. From 2007 – 2008, the company lost over $1.3 billion very much due to goodwill write-downs. While the company could earn $300 million this year, they’ll have to earn far more than that in the future to make their debt manageable.
Demand for Goodyear tires has sunk, and the company is saddled with massive debt and pension obligations. It doesn’t help that The United Steelworkers union prevents the company from proper cost control by forcing factories to stay open. Shareholders have to wonder how much value will be left of the company after bondholders and the union members have their way.
Weak advertising and falling license fees have sent CBS's earnings off a cliff in 2009. If they remain depressed for too long, the company could have trouble refinancing $3.2 billion of debt coming due over the next five years. It will really come down to whether or not CBS’s earnings collapse is merely cyclical, or the result of structural trend whereby traditional TV is dying. As a business blog, we can't help but feel partly guilty here.
Advanced Micro Devices
When will AMD actually make money again? The question is becoming more important by the day since it carries over $5 billion in long-term debt. After losing almost $3 billion from 2007 – 2008, analysts expect the company to lose more money in 2009 and 2010. While the shares rallied from their February $2 low, they still appear stuck in a long-term down trend from $40 highs way back in 2006.
Las Vegas Sands
Las Vegas Sands over-expanded and over-levered in the last few years and now has over $10 billion in debt to deal with. Despite jumping 13 times from their March low, Las Vegas Sands shares still face an uphill battle. Conditions in Las Vegas are horrible, Asian expansion isn’t enough, and if this lasts too long then LVS will end up in bankruptcy court looking like it bit off more than it can chew.
As one of the largest advertising and marketing companies in the world, IPG was slammed by the global recession. As the company’s CEO said during recent second quarter results, the downturn “is proving steeper and more lasting than expected”. Revenues have fallen double digits and the company’s exposure to General Motors as its largest client hasn’t helped.
Long-Term Investors Start To Sell
The markets continue to make new highs, but watch out. Long-term mutual fund investors have reversed this month, selling shares, rather than dumping money in. Based on the first two weeks of the month, September's outflows will be bigger than the inflows seen in the last three months combined.
FDIC Considers Borrowing From Treasury to Shore Up Deposit Insurance
Federal Deposit Insurance Corp. Chairman Sheila Bair said Friday her agency may tap its $500 billion credit line with the U.S. Treasury to replenish its deposit insurance fund, though she appeared cautious about doing so. "We are carefully considering all options" including borrowing from the Treasury, Ms. Bair said Friday after a speech in Washington. Ms. Bair has already warned banks that they may face an assessment increase to bolster the fund. Friday, she said there are also other little-known options available to the agency, including requiring banks to prepay assessments. The FDIC board of directors will meet at the end of this month to consider how to replenish the fund, she said.
Ms. Bair appeared cautious about resorting to the Treasury credit line, saying there are different views on when it should be used. She said some believe it should be reserved for emergencies only, rather than for covering losses that are already known. Congress acted earlier this year to allow the FDIC to borrow as much as $500 billion from the Treasury if the Treasury, the Federal Reserve and the White House believe it is warranted. Otherwise, the agency can borrow up to $100 billion.
The financial crisis has clobbered the FDIC's deposit insurance fund, forcing the agency to impose a special assessment on the industry to rebuild the fund. Ninety-two banks have failed so far this year. The deposit insurance fund fell by $2.6 billion to $10.4 billion during the second quarter, after 24 banks went bust. In a speech at Georgetown University's McDonough School of Business, Ms. Bair strongly cautioned the Financial Accounting Standards Board, or FASB, against expanding market-to-market accounting rules to bank deposits and loans.
Currently, banks are required to write down certain securities to market values when they become impaired. FASB is proposing to extend that to other bank assets, such as loans and deposits. Ms. Bair said the move would create more volatility for bank balance sheets, exacerbating the financial crisis, with no measurable improvement in transparency. "Marking banking assets to market prices doesn't make sense," she said.
Ms. Bair argued that policy makers, after the extraordinary government interventions of the past year, need to work now to dispel assumptions that certain "too big to fail" companies will be bailed out. She said larger, riskier firms should face higher capital charges. She also repeated arguments for creating a process to wind down teetering nonbank financial firms similar to the FDIC's system for resolving banks. "The process is harsh. It is painful. But it works," she said, by sending "a strong message that investors and creditors face losses when banks fail."
Crisis Is Straining Funds of 2 Key Agencies
A year ago, as the financial system was threatening to collapse, federal regulators offered up all sorts of assistance to ward off catastrophe. The strategy worked, at least so far, but the bill is starting to come due. The Federal Housing Administration, which is supporting the housing market by insuring loans for millions of strapped buyers, said Friday that its cash reserves had fallen below 2 percent for the first time. Raising its insurance rates would replenish the reserves, but could also hamper the housing recovery. Another unpleasant option: asking for a federal bailout.
The Federal Deposit Insurance Corporation, meanwhile, is running out of money to pay back the depositors of failed banks. Its chairwoman said Friday that the agency might for the first time decide to borrow from the United States Treasury. Taken together, the two developments indicate “the limits of the government’s ability to make all the bad stuff go away,” said Ed Yardeni, an independent investment strategist.
During the housing boom, borrowers spurned the F.H.A. because it required them to fill out a few forms and come up with a down payment of 3 percent. Subprime lenders, by contrast, asked for neither money nor documentation. The F.H.A. became a wallflower, its share of the market dwindling nearly to nothing. Now the subprime lenders are gone, and traditional banks are so reluctant to issue mortgages that they demand large down payments. But the F.H.A., which works with thousands of lenders to guarantee repayment of mortgage loans, only requires a down payment of 3.5 percent.
The agency’s share of the loan market has risen rapidly, to more than 20 percent. Some of those borrowers are losing their jobs and, as a result, their houses, and the default rate on F.H.A. loans is rising. About 14.4 percent of F.H.A. loans in the second quarter were at least one payment past due but short of foreclosure. That is twice the delinquency rate for top-quality or prime loans, at 6.4 percent. The F.H.A. has become the government equivalent of Countrywide Financial, the hyper-aggressive private lender that crashed two years ago, Mr. Yardeni said. “If you lend money to people with a low probability of paying you back, you shouldn’t be surprised if they don’t,” he said.
F.H.A. officials said Friday that rumors swirling around its reserve fund were untrue. “Reports about the fund being insolvent and needing taxpayer bailout are inaccurate and do not reflect the total health of the fund,” the agency’s commissioner, David H. Stevens, said in a conference call with reporters. “Under no circumstances will a taxpayer bailout be needed.” Nevertheless, the agency is appointing its first chief risk officer since it was founded during the Depression, and is making several policy changes. These include raising requirements on F.H.A. lenders to make sure they have sufficient financial backing, and providing new guidelines on the independence of appraisers, who analyze the value of a home before a sale closes.
At the F.D.I.C., the insurance fund fell to $10.4 billion at the end of the second quarter, the lowest level since the savings and loan crisis of the early 1990s. More than 90 banks have failed so far this year. Another two joined the list late Friday: Irwin Union Bank of Louisville and Irwin Union Bank and Trust of Columbus, Ind. The two banks, which had 27 branches between them, are subsidiaries of Irwin Financial Corp. The F.D.I.C. estimated that the failures would cost its deposit insurance fund $850 million.
Among the options for the F.D.I.C. to replenish its fund are levying a special fee on banks, tapping the Treasury or issuing its own debt, the agency’s chairwoman, Sheila Bair, said Friday at a conference at Georgetown University. Banks are opposed to a fee, but Ms. Bair expressed little enthusiasm for borrowing from the Treasury.
“There is a philosophical question about the Treasury credit line, whether that is there for losses we know we will have or whether it’s there for unexpected emergencies,” Ms. Bair said. Those losses are likely to keep rising into the indefinite future, said Lou Barnes, a mortgage banker in Boulder, Colo. “Government life support is crucial, but the patient has an open artery and each new transfusion of blood is just running out onto the floor,” Mr. Barnes said. “Until we figure out how to seal the artery we’ll have no choice but to keep doing more transfusions.”
The Bill Comes Due, Vexing Housing and Banking Agencies
A year ago, as the financial system was threatening to collapse, federal regulators offered all sorts of assistance to ward off catastrophe. The strategy worked, at least so far, but the bill is starting to come due. The Federal Housing Administration, which is supporting the housing market by insuring loans for millions of struggling buyers, said Friday that its cash reserves had fallen below 2 percent for the first time. Raising its insurance premiums would replenish the reserves, but could also hamper the housing recovery. Another unpleasant option: asking for a federal bailout.
The Federal Deposit Insurance Corporation, meanwhile, is running out of money to pay back the depositors of failed banks. Its chairwoman said Friday the agency might for the first time decide to borrow from the Treasury. Taken together, the two developments indicate “the limits of the government’s ability to make all the bad stuff go away,” said the investment strategist Ed Yardeni. During the housing boom, borrowers spurned the F.H.A. because it required them to fill out a few forms and come up with a down payment of 3 percent. Subprime lenders, by contrast, asked for neither money nor documentation. The F.H.A. became a wallflower, its share of the market dwindling nearly to nothing.
Now the subprime lenders are gone, and traditional banks are so reluctant to issue mortgages they demand large down payments. But the F.H.A., which works with thousands of lenders to guarantee repayment of mortgages loans, only requires a down payment of 3.5 percent. The agency’s share of the loan market has risen rapidly, to more than 20 percent. Some of those borrowers are losing their jobs and, as a result, their houses. The default rate on F.H.A. loans is rising. About 14.4 percent of the agency’s loans in the second quarter were at least one payment past due but short of foreclosure. That is twice the delinquency rate for top-quality or prime loans, at 6.4 percent.
The F.H.A. has become the government equivalent of Countrywide Financial, the hyper-aggressive private lender that crashed two years ago, Mr. Yardeni said. “If you lend money to people with a low probability of paying you back, you shouldn’t be surprised if they don’t,” he said. F.H.A. officials said Friday that rumors swirling around its reserve fund were untrue. “There will be no taxpayer bailout, there will be no special appropriations, no legislation, no action requesting any additional funds whatsoever,” said David H. Stevens, the F.H.A.’s commissioner, in a conference call with reporters.
Nevertheless, the agency is appointing its first chief risk officer since it was founded during the Great Depression, and is making several policy changes. These include raising requirements on F.H.A. lenders to make sure they have sufficient financial backing, and providing new guidelines on the independence of appraisers, who analyze the value of a home before a sale closes. At the F.D.I.C., the insurance fund fell to $10.4 billion at the end of the second quarter, the lowest level since the savings and loan crisis of the early 1990s.
More than 90 banks have failed this year. Another two joined the list Friday: Irwin Union Bank of Louisville, Ky., and Irwin Union Bank and Trust of Columbus, Ind. The two banks, which had 27 branches between them, are subsidiaries of Irwin Financial Corporation. The F.D.I.C. estimated that the failures would cost its deposit insurance fund $850 million. Among the options for the F.D.I.C. to replenish its fund are levying a special fee on banks, tapping the Treasury or issuing its own debt, the F.D.I.C.’s chairwoman, Sheila C. Bair, said Friday at a conference at Georgetown University. Banks are opposed to a fee, but Ms. Bair expressed little enthusiasm for borrowing from the Treasury.
“There is a philosophical question about the Treasury credit line, whether that is there for losses we know we will have or whether it’s there for unexpected emergencies,” Ms. Bair said. Those losses are likely to keep rising into the indefinite future, said Lou Barnes, a Boulder, Colo., mortgage banker. “Government life support is crucial, but the patient has an open artery and each new transfusion of blood is just running out onto the floor,” Mr. Barnes said.
FHA's Refusal to Seek Bailout Met With Skepticism
The Federal Housing Administration's assertion that it will not need to ask for a bailout even though its loss reserves are eroding was met with skepticism Friday from the agency's longtime critics. FHA Commissioner David H. Stevens said Friday that the surplus fund set aside to cover unexpected losses on mortgages backed by the agency will fall below the 2 percent threshold required by Congress when the next fiscal year starts in October.
The housing bust has taken its toll on the agency, Stevens said. But he insisted that the FHA will not ask taxpayers to kick in for the shortfall or raise premiums because it has more than $30 billion in cash to cover future losses. He dismissed as erroneous previous claims by government officials that those were the only two options available to the agency should its reserves dip below mandatory levels. But critics of the FHA said they question the agency's financial soundness. They say that the job market and overall health of the economy are big unknowns going forward, and further deterioration on either front could send FHA scrambling for a bailout.
The shrinking loss reserves "is just the tip of the iceberg as job losses continue to mount, and more and more homeowners are expected to lose value in their homes," Sen. Christopher S. Bond (R-Mo.) said in a statement. "It's critical we address FHA's problems now because the taxpayer credit card is maxed out." Mark Calabria, director of financial regulation studies at the Cato Institute, said Stevens seems committed to "cleaning up" the agency he took over in July. But so much is out of the agency's control, he said.
"The only way they will survive without taxpayer assistance is if the housing market turns around and the labor market turns around fairly soon," said Calabria, a former Republican staffer on the Senate Banking Committee. "Nobody has a crystal ball right now." One of the key problems dogging the housing market has been plummeting home prices, which left many borrowers owing more than their homes were worth and making it impossible for them to sell or refinance their way out of trouble. They lapsed into foreclosure, and those foreclosures have helped drag prices down further.
The FHA said that the results of an independent audit due out in November will be based partly on home price forecasts calculated by an outside firm, which show price declines continuing through the first quarter of 2010. Based on that assumption, the audit concluded that FHA's reserves will bounce back to the necessary threshold in the next two to three years, Stevens said. Although the reserves had remained well above the minimum required level during the housing boom, the audit last year showed they had shrunk to 3 percent as of Sept. 30, compared with 6.4 percent a year earlier. The fund's value was estimated at $12.9 billion, down from $21.2 billion the previous year.
Stevens proposed new policies Friday that he said will help the reserves recover even sooner. Two of the measures address fraudulent loans. One would require banks and other lenders that do business with the FHA to have at least $1 million in capital to repay the agency for losses if they were involved in fraud. Now, they are required only to hold $250,000. Another would require lenders to be responsible for any losses due to fraud committed by the mortgage brokers with whom they work. Stevens also said he plans to hire a chief risk officer for the first time in the agency's 75-year history to help reduce losses going forward. Brian Montgomery, FHA commissioner under President George W. Bush, said Friday that these were all "good steps" and that he does not expect the agency will need a bailout.
While the agency has been attracting more business from more creditworthy borrowers, its newest loans are falling into default at a higher rate, according to the latest publicly available FHA data. The number of borrowers falling 90 days behind on their loans within the first two years was 4.6 percent at the end of July, up from about 3.5 percent a year earlier. The number of new loans being insured has more than doubled from a year ago, but the number of those new loans in default has tripled. Guy Cecala, publisher of Inside Mortgage Finance, said the audit is based on future assumptions and "none of us know what the future is going to be. We've always felt you could make the insurance fund look as good or bad as you want regardless of the economics of it, depending on your goal."
Is Wells Fargo Making AIG’s Suicidal Mistake?
Wells Fargo may be making the same mistake that destroyed AIG, turning the insurance company into a seemingly endless blackhole of losses. The San Francisco bank has responded with irritation to media reports and questions from research analysts about its derivatives exposure. It insists it has a firm handle on the losses it could take from credit default swaps Wachovia sold and it inherited.
Maybe. We read closely the company’s annual report. It has a brief and very boring discussion of exposure to credit derivatives. But nowhere does the company express an awareness of (or exposure to) what we now think of as Collateral Call Risk. It was not bond defaults that killed AIG, after all. It was collateral calls.
Recall that AIG also thought that it was exercising the utmost caution, hiring a Wharton/Yale professor to build "risk models," and AIG was confident that many of the bonds on which it wrote insurance would never default. And AIG was right—many of those bonds didn’t default and still haven’t. But that wasn’t enough to save AIG. What AIG's risk models missed was the possibility that AIG would have to post additional collateral in the event of a decline in the value or ratings of bonds that had yet to default. They had only analyzed the likelihood that they would be forced to pay off credit default swap policies insuring bond defaults.
In other words, AIG's PhDs analyzed only the most unlikely risk the company faced--defaults--and not a far more likely risk: That the value of the bonds it was insuring might decline, forcing it to come up with more capital as collateral. Is it possible that even after AIG, Wells Fargo could make the same stupid mistake? Could they really have overlooked Collateral Call risk?
At this point, given the widespread idiocy in the banking sector, anything's possible. We’re not sure Wells Fargo has overlooked this risk. We’re not even sure that the company has this risk—their annual report discussion isn’t detailed enough for us to tell. But neither, we expect, was AIG's. We’re told that the right to demand more collateral is completely standard in such credit default swaps, so it is likely that Wells does have Collateral Call Risk. Which is what makes it alarming that we haven’t seen evidence that they have taken this risk into account.
In fact, when Wells Fargo does discuss its exposure to the credit default swaps, it sounds frighteningly like AIG, assuring us that the likelihood of the repurchase obligations being triggered is remote and that the residual value of the underlying bonds hedges the risk. But it says nothing about collateral risk. Here’s the discussion in the annual report:In certain loan sales or securitizations, we provide recourse to the buyer whereby we are required to repurchase loans at par value plus accrued interest on the occurrence of certain credit-related events within a certain period of time. The maximum risk of loss represents the outstanding principal balance of the loans sold or securitized that are subject to recourse provisions, but the likelihood of the repurchase of the entire balance is remote and amounts paid can be recovered in whole or in part from the sale of collateral. In 2008 and in 2007, we did not repurchase a significant amount of loans associated with these agreements.
As we said, there are two possible ways to account for the lack of discussion of Collateral Call Risk. Either Wachovia wrote its derivative contracts in ways that don’t permit buyers to demand more collateral or Wells Fargo is not disclosing this risk. (A third possibility—that they don't even seem aware that they have this risk — seems remote after AIG.)
Wells Fargo’s Commercial Portfolio is a Ticking Time Bomb
by Teri Buhl
In order to sort through the disaster that is Wells Fargo’s commercial loan portfolio, the bank has hired help from outside experts to pour over the books… and they are shocked with what they are seeing. Not only do the bank’s outstanding commercial loans collectively exceed the property values to which they are attached, but derivative trades leftover from its acquisition of Wachovia are creating another set of problems for the already beleaguered San Francisco-based megabank, Wachovia, which Wells purchased last fall as it teetered on the brink of collapse, was so desperate to increase revenue in the last few years of its existence that it underwrote loans with shoddy standards and paid off traders to take them off their books.
According to sources currently working out these loans at Wells Fargo and confirmed by Dan Alpert of Westwood Capital, when selling tranches of commercial mortgage-backed securities below the super senior tranche, Wachovia promised to pay the buyer’s risk premium by writing credit default swap contracts against these subordinate bonds. Should the junior tranches eventually default, then the bank is on the hook.
Alpert says in reference to how he saw CMBS trades get done, “The Wachovia guys would say ‘We’ll just take back that silly credit risk you’re worried about.’ Of course that was a nice increase to earnings when they got the security sold. The bank made money at the time.” When asked if Wells Fargo was prepared to pay out those credit default swaps if these securities default, a spokeswoman told Bank-Impode.com,” In keeping with our strong risk discipline, we continually monitor all of our outstanding derivative positions. We have provided extensive transparent disclosures on our derivatives in our 2008 annual report beginning on page 132.”
The real question is, however, was enough disclosed to investors about this practice when Wells purchased Wachovia? One top hedge fund manager who has experience in outing accounting fraud told Bank-Implode “They needed to estimate that CDS liability upon the purchase of Wachovia. If they didn’t, they’ve committed fraud.” Since there is no way to track the amount of contracts Wachovia wrote due to the lack of a central clearinghouse for credit default swaps , the next best option for analysts is to examine how the loans that backed the mortgage securities are performing. An in-depth review by Bank-Implode shows significant weakness regardless of Wells Fargo’s recent claim to the Wall Street Journal that the merger integration is on track.
According to the New York Post, Harry Markopolos, the whistleblower on Bernie Madoff, gave a speech this summer at the Greek Orthodox Church in Southampton predicting more major scandals will soon be revealed about the unregulated, $600 trillion, credit default swap market. Ouch! One senior member of Wells Fargo’s commercial loan group who deals directly with the quandary, who spoke on the condition of anonymity, says, “One third of this commercial portfolio we took on from Wachovia is impaired and needs to be completely rewritten. I’ve just hired five more guys and we can’t keep up with the volume of defaults. Southeast Florida and Tampa are serious trouble spots.”
Wachovia’s third quarter 2008 filings, which reflect their assets three days before Wells Fargo agreed to the acquisition, shows the bank held a whopping $230 billion in its commercial loan portfolio. Current figures show Wells’ 90-day defaults on its commercial portfolio are rapidly growing. According to data from WLMlab.com which tracks financial numbers that Wells files with its regulators, the bank’s Construction and Development portfolio, with $38.2 billion in loans, is defaulting at a level eight times greater than the rest of the nation’s banks, as of June 30th.. Alarming right?
Wachovia commercial loan officers who spoke to Bank Implode say that the bank specialized in underwriting short-term loans up to five years during the credit boom of 2005-2007. The standard terms for such loans included interest-only payments on a floating rate with a huge balloon payment in the final year of the loan. If these loans cannot be refinanced, more waves of defaults are inevitable.
According to Susan Smith, author of a recent PriceWaterhouseCoopers investor survey about the state of the CMBS market, more trouble is brewing. “It’s going to be very difficult for these loans to get refinancing when the market value is going down and fundamentals are deteriorating,” says Smith. According to data from her report, problems in the South Florida region, to which Wachovia had large exposure, are amplified by an increasing overall cap rate, up 80 basis points from last year, and declining rent prices. The OCR is the perception of risk investors see. The overall cap rate goes up when the overall risk in the market is up.
Given the warning signs on the horizon, it’s plausible that Wells Fargo would try to unload some of these troubled loans on the secondary market. But according to multiple private investment shops set up to invest in distressed debt, Wells isn’t selling them. If Wells were to sell the loans, not only would the bank have to book a loss, but would also have to pay out those pesky credit default swaps. Instead of selling the loans, sources inside Wells commercial group told Bank Implode that they have been instructed to modify loans for customers in default by adjusting the interest rate, but not change the maturity date. Why?
According to Meredith Whitney, founder and CEO of Meredith Whiney Advisory Group, Wells is working an accounting game of “extend and pretend.” “If the bank doesn’t change a maturity date, then it does not have to take an impairment charge on its books, which would affect earnings,” says Whitney. If the loans don’t look like they are impaired, the rating agencies then do not have to downgrade the billions of CMBS that Wachovia sold to other banks and investors. Moody’s backed out of such a downgrade last month, after it previously warned downgrades were coming on $4.1 billion of Wachovia Bank commercial mortgage securities because it now expects principal and interest payments to continue.
Adds Whitney “We’ve seen Wells Fargo play modification games with its own loans. Why wouldn’t they do it with the loans they took on from Wachovia?” On Tuesday on CNBC, Whitney said again “I don’t know if those commercial modifications are going to work.”
In response to analyst expressing doubts that the near $40 billion structured into the purchase of Wachovia for losses in its total portfolio will be enough CEO John Stumpf spoke out. Stumpf told investors at the Barclays conference this week, Wells Fargo has used $2.2 billion in credits for losses from Wachoiva’s commercial mortgages, or one-fifth of the $10.4 billion in total losses it expects from those loans. Unfortunately for investors, banks hold CDS liabilities off balance sheet and do not recognize them as a loss until they actually have to pay it.
Wachovia at least disclosed in its third quarter 2008 10-K on note 15, that credit derivatives are a regular part of how they finance commercial activities, and add that such instruments ‘don’t meet the criteria for designation as an accounting hedge’. Given that a specific number for CDS exposure is not yet tenable, it’s hard to say how many billions are at risk. Yet most market players who follow this bank said when those CMBS de-lever and the derivatives come due, it will be a problem for which Wells is absolutely not adequately capitalized.
To give Wells Fargo credit, it might not even know the size of the problem. Bank Implode could not find an analyst who covers the stock to say Wells actually has enough loss reserves built in for it, but regardless the analysts are very concerned about the bank’s health based on the data that they do see. Both Whitney and Paul Miller of FBR Capital Markets both have gone on-air and written in notes [http://bankimplode.com/blog/2009/08/07/is-it-time-to-short-well/] to clients that Wells’ loan loss reserves are not enough to handle coming impairments to residential loans. Miller has a recommended stock price of $15 while WFC is currently trading around $29.
So how can Wells really have enough capital to handle the liability of credit derivatives that will likely come due within the year? As we watch more and more of the junior tranches of commercial mortgage back securities Wachovia sold become worthless how will Wells Fargo afford to pay for the risk premiums Wachovia promised they’d take care of if the loans blew up? From all indications, the bank cannot meet these obligations unless it raises more capital, sells good assets for a loss, or put more of that TARP money to use that CEO John Stumpf says is coming back to the taxpayer. So much for “earning our way out” of the financial crisis.
Bove: Wells Fargo Sitting On A Volcano About To Explode
As we wrote earlier this week, outside experts hired by Wells Fargo to examine its books are reportedly shocked at the bank’s exposure to derivatives trades it took on when it acquired Wachovia, fearing these may trigger huge losses at the bank. And now Dick Bove is also worried about the bank, seeing a “volcano, with numbers of tremors, that is possibly about to blow.” Bove says the gap between management views of the company and shareholders may be growing and he outlines a set of reasons that could lead one to believe Wells is either delusional or trying to do its best to postpone the inevitable.
The most troublesome point is the bank’s “questionable“ loans and securities, which seem like a ticking time bomb. Bove says that outsiders are convinced that the bank is understating its loan problems in the home equity, commercial real estate, and credit card arenas. Bove adds that there are significant issues being raised concerning the bank’s valuation techniques in its derivatives portfolio and its accounting in these areas.There is constant argumentation over the bank’s methodologies in valuing its mortgage servicing portfolio. Additionally, a number of state attorney generals are unhappy with certain of the bank’s mortgage sales practices.
Then, regarding the bank’s balance sheet, he says that Wells may be forced by the imposition of Basel II accounting rules to add hundreds of billions in assets to it, and If so, the company will be forced to sell a sizable amount of equity. Finally, the Wachovia merger itself is also as source of tremors, he says as he thinks that Wells has not adequately reserved for the multiple problems within legacy Wachovia. "I am on the side of believing more capital will be needed," Bove writes.
Homeowners who 'strategically default' on loans a growing problem
Who is more likely to walk away from a house and a mortgage -- a person with super-prime credit scores or someone with lower scores? Research using a massive sample of 24 million individual credit files has found that homeowners with high scores when they apply for a loan are 50% more likely to "strategically default" -- abruptly and intentionally pull the plug and abandon the mortgage -- compared with lower-scoring borrowers.
National credit bureau Experian teamed with consulting company Oliver Wyman to identify the characteristics and debt management behavior of the growing numbers of homeowners who bail out of their mortgages with none of the expected warning signs, such as nonpayments on other debts.
With foreclosures, delinquencies and loan losses at record levels, strategic defaults and walkaways are among the hottest subjects in residential real estate finance. Unlike in earlier academic studies, Experian and Wyman could tap into credit files over extended periods to identify patterns associated with strategic defaults. Among researchers' findings are these eye-openers:
- The number of strategic defaults is far beyond most industry estimates -- 588,000 nationwide during 2008, more than double the total in 2007. They represented 18% of all serious delinquencies that extended for more than 60 days in last year's fourth quarter.
- Strategic defaulters often go straight from perfect payment histories to no mortgage payments at all. This is in stark contrast with most financially distressed borrowers, who try to keep paying on their mortgage even after they've fallen behind on other accounts.
- Strategic defaults are heavily concentrated in negative-equity markets where home values zoomed during the boom and have cratered since 2006. In California last year, the number of strategic defaults was 68 times higher than it was in 2005. In Florida it was 46 times higher. In most other parts of the country, defaults were about nine times higher in 2008 than in 2005.
- Two-thirds of strategic defaulters have only one mortgage -- the one they're walking away from on their primary homes. Individuals who have mortgages on multiple houses also have a higher likelihood of strategic default, but researchers believe that many of these walkaways are from investment properties or second homes.
- Homeowners with large mortgage balances generally are more likely to pull the plug than those with lower balances. Similarly, people with credit ratings in the two highest categories measured by VantageScore -- a joint scoring venture created by Experian and the two other national credit bureaus, Equifax and TransUnion -- are far more likely to default strategically than people in lower score categories.
- People who default strategically and lose their houses appear to understand the consequences of what they're doing. Piyush Tantia, an Oliver Wyman partner and a principal researcher on the study, said strategic defaulters "are clearly sophisticated," based on the patterns of selective payments observable in their credit files. For example, they tend not to default on home equity lines of credit until after they bail out on their main mortgages, sometimes to draw down more cash on the equity line.
Strategic defaulters may know that their credit scores will be severely depressed by their mortgage abandonment, Tantia said, but they appear to look at it as a business decision: "Well, I'm $200,000 in the hole on my house, and yes, I'll damage my credit," he said of defaulters. But they see it as the most practical solution under the circumstances.
The Experian-Wyman study does not try to explore the ethical or legal aspects of mortgage walkaways. But it does suggest that lenders and loan servicers take steps to screen and identify strategic defaulters in advance and possibly avoid offering them loan modifications, since they'll probably just re-default on them anyway.
Unemployed homeowners could get financial assistance
The Obama administration is engaged in high-level talks about providing financial assistance to homeowners who've lost their jobs and can't afford their mortgage payments. The Treasury Department held meetings on the subject as recently as Thursday with key stakeholders, according to Laura Armstrong, a spokeswoman for Hope Now, an alliance of non-profits and mortgage servicers, and more discussions are planned.
Proposals include getting servicers to let jobless homeowners skip some monthly payments, according to Faith Schwartz, executive director of Hope Now. Another possibility that has been discussed includes grants or loans to temporarily cover part of the mortgage costs for homeowners who become unemployed, says Paul Willen, a Federal Reserve Bank of Boston economist. "Treasury has now brought us all together," says Jack Shackett, Bank of America's head of credit-loss prevention, who is involved in the discussions.
"Even if it takes Treasury awhile to get some guidance out, the talking itself is great," Shackett says. Treasury officials declined to comment. No time line for any new government initiative has been set, says Schwartz, who is also involved in the talks. The meetings have included major lenders, economists and government officials from Treasury, the Department of Labor, Hope Now and the Federal Reserve. The discussions come after a $75 billion plan announced in March by the administration. That plan seeks to prevent foreclosures and get homeowners into more affordable mortgages but has been criticized for getting off to a slow start.
But now, with unemployment nearing double digits, some economists say efforts to prevent foreclosures must also involve financial help to homeowners who lose jobs. Otherwise, they say the housing recovery could stall. "We're seeing interest at high levels," Willen says. "At this point, the idea that unemployment is the real problem (in the housing crisis) is the conventional wisdom on Capitol Hill." Some real estate groups applauded the talks, saying mounting joblessness will haunt any housing recovery.
"I've not been a part of the discussions, but we are aware of them," says Lawrence Yun, chief economist at the National Association of Realtors. "If we want to prevent foreclosures, something needs to be done, and it's not mortgage modification," says Morris Davis, an assistant professor of real estate and urban land economics at the University of Wisconsin-Madison, and one of the authors of a relief plan that would provide housing vouchers attached to unemployment insurance.
Watch Barclays in the cellar
by Gillian Tett
A couple of years ago, when structured investment vehicles were sowing devastation in the financial world, I frantically searched for a way to explain to non-financiers how these entities worked. The analogy I resorted to was a garage or cellar. For just as a garage or cellar is usually attached to a house – but not truly inside a house – entities such as SIVs and conduits have traditionally had a semi-detached status with banks. That served the banks dangerously well in the years of the credit boom, since they used SIVs as a place to store irritating stuff which they did not want cluttering up their balance sheet – such as a household stuffing rubbish into a cellar, so that it does not mess up the smart front room.
These days, of course, the word “SIV” has become almost as taboo as the phrase “subprime securitisation”. Yet, as I perused this week’s announcement that Barclays plans to sell $12.3bn of credit assets to a “newly established fund” called Protium Finance – which will be independent but mostly financed by a loan from Barclays – it was hard to escape a twinge of déjà vu. To be sure, the details of the Barclays plan differ in some crucial ways from the old SIVs-cum-cellars. One central sin that bedevilled the SIVs was that banks often used them for regulatory arbitrage. Another was a reliance on cheap, short-term financing – which disappeared, with disastrous consequences, when the crisis started in 2007.
However, as Barclays repeatedly stressed this week, Protium is not focused on regulatory arbitrage: those $12.3bn assets will stay on Barclays’ balance sheet for regulatory purposes, in the sense that the bank will be forced to make big capital provisions against a $12.6bn loan it is extending to Protium. Moreover, Protium is not exposed to the funding risk that blew up the SIVs, thanks to that monster loan. But in another sense, there is an uneasy echo of the past. Most notably, by selling those $12.3bn assets to Protium, what Barclays is essentially doing is taking a pile of toxic items out of its front room (ie the balance sheet) and stuffing it into an entity that is not inside the house (the garage, or cellar).
After all, the fine print of the Barclays announcement makes it clear that while the British bank is going to count the Protium assets as being “on balance sheet” for regulatory purposes, it is removing the assets from the balance sheet in accounting terms, since Protium is legally “independent”, based in the Cayman Islands. That means the bank will not need to report the mark-to-market value of those assets, or reveal the source of equity finance for Protium that supplements the Barclays loan. Nor will it need to control the pay of the people running Protium, since they do not count as Barclays staff.
Now, many bankers would argue that such ring-fencing is not just sensible, but inevitable in the current world. Putting these assets into a dedicated unit, after all, puts them under the control of an experienced management team. It also makes the “front room” of Barclays look smarter, since it shields the main balance sheet from sudden fluctuations in the value of toxic assets – and clarifies for shareholders where those assets are. In many ways, that represents progress. After all, at many western banks it is still a mystery what is (or is not) happening to all those troubled credits, or who is (or is not) sorting them out.
Yet, in spite of all those benefits, the fact remains that Protium is still the financial equivalent of a cellar: namely a dark place that is outside public scrutiny, but implicitly linked to the main financial “house”. And that points to a crucial challenge which is now dogging regulators – and which goes well beyond Barclays itself. For the really dirty secret that currently bedevils the whole financial reform debate is that the more that regulators force banks to clean up their “front rooms” (ie regulated activity), the greater the risk that activity will flee to unregulated corners of finance – if nothing else because financiers have little desire to subject their pay to public scrutiny.
In theory, regulators could prevent that outflow, if they were willing to clamp down on the unregulated world in a co-ordinated way. In practice, though, western leaders are finding it so tough to agree on how to reform the front rooms of finance that I seriously doubt they will have the energy to attack the cellars too. Thus far, few banks have had the political chutzpah to exploit that situation too brazenly. Barclays, however, now appears to be blazing a trail of sorts – and I would hazard a bet that plenty more banks will be tempted to follow suit. So stand by to see more Protium-style deals emerge in the coming months. After all, financial cellars can come in numerous forms – and, it would seem, ever more weird names.
Joseph Stiglitz says recession's end by 2012 "an optimistic view"
Did you hear? The recession is over! Or at least it will be in the foreseeable future! And several of our leading economic sages have said so, so that makes it true. Or does it? Not when there's a prominent naysayer like Joseph Stiglitz. The Nobel-winning economist, a former head of the World Bank and now a professor at Columbia University, has a blunt -- if characteristically bearish -- warning of more economic turbulence ahead.
Stiglitz's outlook is anything but rosy. Americans must prepare for the recession to continue until 2012 -- practically, if not technically -- he said this week in an interview with DailyFinance. Stiglitz blasts the use of complex derivatives, which he says go against "the social good," and he reserves special contempt for Goldman Sachs and the $13 billion injection it received from the U.S. as part of AIG's counter-party bailout last year.
Just after returning to New York from Japan, Britain, and economically devastated Iceland, Stiglitz paints a picture of a U.S. economy that has stanched the most serious bleeding but remains deeply wounded. "I think we would be lucky to be out of the recession by 2012," Stiglitz says. "2010 may be a year of positive growth, though far weaker than would be necessary to get unemployment down significantly." Central to the grim diagnosis, Stiglitz says, is the lack of new jobs -- an argument echoed by the Organisation for Economic Cooperation and Development, which this week said high unemployment in the world's wealthiest countries could last years.
With President Obama's stimulus program ending in 2011, the U.S. faces continuing turmoil, says Stiglitz. "There is likely to be weakness again in the economy in 2011," Stiglitz says. "2012 is an optimistic view of when we could be over the travails. The technical term 'recession' is two quarters of negative growth, and we're likely to have positive growth this quarter and next quarter -- but that's not what most people mean by 'out of recession.' Most people mean, 'Are jobs plentiful? Is unemployment low? Are wages strong?' And in those core ways, we are far from being out of the recession."
Still, economic conditions have improved over a year ago, Stiglitz allows. "We're no longer at the precipice, but there are many bumps ahead," he says. "The couple million homes in foreclosure, commercial real estate, high unemployment, mean that some people are not going to be able to repay loans that are outstanding. The banking system is by no means out of the woods. There is reason to believe that there will be continue to be bankruptcies of the banks."
Stiglitz is particularly troubled by the continued failure of small to medium-sized banks that provide the lifeblood of capital to the country's small businesses. "That will impair the 'real' sector, and create more unemployment, and contribute to the vicious weakness and downward cycle of the economy."
Stiglitz also criticizes the government's bailout of the major Wall Street banks. "There certainly are questions about the AIG bailout," Stiglitz says. "$180 billion went to AIG. That's a lot of money. And when we finally got the disclosure of where the money was going from AIG, the original suggestion was that it was because of concern about systemic risk. The largest recipient was Goldman Sachs, which said they did not need that money.
"But questions could be raised about whether they were just saying that," he continues. "The main problem that Goldman raises is a question of size: 'too big to fail.' In some markets, they have a significant fraction of trades. Why is that important? They trade both on their proprietary desk and on behalf of customers. When you do that and you have a significant fraction of all trades, you have a lot of information."
Further, he says, "That raises the potential of conflicts of interest, problems of front-running, using that inside information for your proprietary desk. And that's why the Volcker report came out and said that we need to restrict the kinds of activity that these large institutions have. If you're going to trade on behalf of others, if you're going to be a commercial bank, you can't engage in certain kinds of risk-taking behavior."
On the issue of complicated financial products developed by Wall Street firms to manage risk, Stiglitz was blunt: "I cannot find a social good in complex derivatives. They were designed to manage risk, but they actually increased risk." Some countries, he notes, don't allow them.
A New 'Carry-Trade' Currency? U.K. Pound Emerges as Possibility
The U.K. pound could be turning into one of the currencies that foreign-exchange traders love to hate. The role of "funding currency," at it is known in the markets, had belonged primarily to the Japanese yen in recent years. Investors would take advantage of low Japanese interest rates to borrow yen and invest in currencies such as the Australian and New Zealand dollars, which are linked to higher interest rates and thus offer higher yields. Sterling used to be on the list of those higher-yielding currencies. Broadly, if the Australian and New Zealand dollars were rising on a particular day, sterling would move up, too.
While hard data on how investors use the so-called carry-trade are hard to come by, the pound is currently trading lower against the "Aussie" and the "Kiwi" than it has in more than a decade, as they have soared to 2009 highs against the U.S. dollar. "We have a new funding currency in the pound," said Neil Mellor, a currency analyst at Bank of New York Mellon in London. To be sure, sterling is now a good deal stronger against the yen than at the start of the year. But it has fallen about 6.5% against the Japanese currency since early August, and is trading around 150 yen.
More dramatically, sterling has dropped by nearly 7% against the Australian dollar since early August, trading around A$1.90. And the pound is around an 11-year low against the New Zealand dollar, at around NZ$2.30. By contrast, though the yen has fallen heavily against the Aussie and the Kiwi over the course of the year, the pound has lost much more ground against them over the past two months while the yen has held steady against them for several weeks. A key reason is the outlook for British rates. Economic data in the U.K. generally point to a decent recovery. But Bank of England Gov. Mervyn King reminded markets this week that U.K. interest rates still have room to fall, leading to a weaker pound.
His suggestion to lawmakers Tuesday that a drop in official deposit rates could be a "useful supplement" to monetary policy shoved sterling sharply lower. In effect, Mr. King helped to firm up the possibility that the pound could become the new yen. Just like Japanese interest rates in the early years of this century, U.K. rates clearly have little chance of rising for some time. In another mirror image of the Japanese experience, central-bank asset purchases show no solid sign of coming to an end. If that was bad news for the yen from 2001 to 2007, it could be bad news for the pound now, too.
Still, identifying sterling as a funding currency like the yen has been in the past is tricky. For one thing, the U.K. doesn't have the large current-account surplus that Japan held at the start of this century, so the two currencies do have important differences. In addition, anyone looking for a low-yielding currency to sell has a wide choice right now, including the dollar, which is becoming widely touted as a new funding currency in its own right. Moreover, many believe it is tough to try to seek profits from selling sterling against the U.S. dollar, because the greenback's own problems are likely to keep that currency pair stable.
The pound has long been a high-yield currency, so a shift to behaving like key lower-yielding denominations would be a sharp break with normal patterns. For some, it is too big a leap. "Never say never," said Thanos Papasavvas, a currency investor at Investec Asset Management in London. "But it would be quite a change to have sterling as a funding currency."
The dollar carry trade: Hedge Funds’ ATM Moves From Tokyo to Washington
China is getting all worked up about the wrong thing when it comes to the U.S. Forget these nascent trade wars over tires, cars and chickens. China’s real problem is how quickly the dollars they hold in great quantity are getting all the respect of pesos these days. Sound like hyperbole? Not when you consider what may be the hottest investment of 2010: the dollar-carry trade. Move over Japan. Investors spent a decade borrowing in zero-interest-rate yen and putting the funds in higher-yielding assets overseas. It’s the U.S.’s turn to flood the world with cheap funding and the risks of this going wrong are huge.
The carry trade has never been a proud part of Japan’s post-bubble years. Officials in Tokyo rarely talk about the yen’s role in funding risky or highly leveraged bets on markets from Zimbabwe to New Zealand. Japan never set out to become a giant automated teller machine for speculators. It was a side effect of policies aimed at ending deflation. The perils of the carry trade were seen in October 1998. Russia’s debt default and the implosion of Long-Term Capital Management LP devastated global markets. It was a decidedly panicky and messy period culminating in the yen, which had been weakening for years, surging 20 percent in less than two months.
Now imagine what might happen if the world’s reserve currency became its most shorted. Carry trades are, after all, bets that the funding currency will weaken further or stay down for an extended period of time. It’s also a wager that a central bank is trapped into keeping borrowing costs low indefinitely. “The dollar is the cheapest funding currency bar none and only challenged by the U.K. in terms of the risks from money printing and escalating deficits,” says Simon Grose-Hodge, a strategist at LGT Group in Singapore. Three-month London interbank offered rates, or Libor, for dollar loans are at a record low and fell below those for the yen on Aug. 24 for the first time in 16 years.
Think about the turbulence that would be unleashed by the dollar suddenly shooting 5 percent or 10 percent higher with untold numbers of traders around the globe on the losing side of that trade. It could make the “Lehman shock” look manageable. The U.S. once was a beneficiary of carry trades. The gap between U.S. and Japanese bond yields offered a payoff. You could borrow for almost nothing and buy U.S. debt, receiving a twofold benefit: the 3-plus percentage-point yield difference and the dollar’s strengthening versus the yen. The latter dynamic boosts profits when they are converted back to yen.
Yen borrowers bought everything from Shanghai properties to Google Inc. shares, bars of gold, Zambian treasury bills and derivatives contracts. The odd thing, however, was the lack of credible data. When I asked Japanese officials in recent years for estimates of how big the yen-carry trade had become, I got blank stares. That’s what makes such a trade worrisome and easy to dismiss as a threat to markets. No one knows how big it is -- how many companies, hedge funds or mutual funds borrowed or how much. So when a currency turns suddenly, the magnitude of the unwinding is often a surprise.
The dollar is under pressure for valid reasons. Deficits are widening faster than U.S. officials can measure, and debt- issuance plans are increasing. The U.S. is in recession and the Federal Reserve is still shoveling liquidity into markets. Add to that China’s growing concerns about its dollar holdings -- more than $800 billion of U.S. Treasuries -- which may lead to fewer Chinese purchases. That also goes for Japan, which has $725 billion of U.S. debt.
Really, betting against the dollar would seem to be as safe as assuming Japanese 10-year bond yields will stay at less than 2 percent. And if Treasury Secretary Timothy Geithner and Fed Chairman Ben Bernanke aren’t careful, the dollar will become the main trade dispute with China. U.S. President Barack Obama’s 35 percent tariff on tires from China spurred a Chinese investigation into prices of U.S. poultry and car products. That’s small beer compared with the magnitude of the task facing Geithner and Bernanke should China pull the plug on Treasuries.
China would be hard-pressed to do that, of course. Its dollar holdings are about keeping the yuan low and helping exporters. Still, any hint China would be buying fewer Treasuries could send the dollar lower. What if, for example, a U.S. recovery comes faster than expected, sparking a massive reversal of the carry trade? Its implications would be felt far more widely than shifts in yen bets. Increased dollar volatility could even bring down a few hedge funds and the odd investment bank. The dollar-carry trade says nothing good about confidence in the U.S. economy. It’s also a reminder that the side effects of this crisis may be setting us up for a bigger one.
SEC Looks to Prohibit Flash Trade, Curb Raters
The Securities and Exchange Commission proposed banning flash orders, which give certain large traders sneak peeks at market activity, responding to concerns that some investors are getting an unfair advantage. In a flash order, a firm wishing to buy or sell stock can elect to freeze the order on an exchange for as long as half a second. Critics say this gives a select group of high-speed traders a window into the direction of the market and lets them make lightning-quick trades to profit.
SEC Chairman Mary Schapiro said flash orders may result in a "two-tiered market" and noted "the interests of long-term investors should be upheld as against those of professional short-term traders when those interests are in conflict." The flash proposal, approved 5-0, is the first of several rules the SEC is studying to change the structure of stock markets. This fall, the SEC is expected to tackle dark pools, which are private electronic networks that match orders anonymously.
The SEC also passed rules aimed at reducing conflicts of interest at credit-ratings firms, which have been blamed for contributing to the financial crisis by giving mortgage-backed securities and other products rosier ratings than warranted. The agency also voted to eliminate credit ratings from certain SEC rules, hoping to foster more due diligence by investors and less reliance on ratings. The SEC required ratings firms to disclose all upgrades, downgrades and withdrawals on products they rate. Firms, such as McGraw-Hill Cos.' Standard & Poor's, Moody's Corp.'s Moody's Investors Service and Fimalac SA's Fitch Ratings, also would be required to share information used in ratings with other ratings providers in certain cases. The SEC hopes the step will encourage more competition.
The SEC is also weighing possible rules to deter "rating shopping," in which debt issuers get preliminary ratings and then select the rate they like best. The agency also voted to study whether it should rescind a rule that has given credit-ratings firms protection from some types of investor lawsuits.
New Rule: You Can't Complain About Health Care Reform If You're Not Willing to Reform Your Own Health
by Bill Maher
New Rule: You can't complain about health care reform if you're not willing to reform your own health. Unlike most liberals, I'm glad all those teabaggers marched on Washington last week. Because judging from the photos, it's the first exercise they've gotten in years. Not counting, of course, all the Rascal scooters there, most of which aren't even for the disabled. They're just Americans who turned 60 and said, "Screw it, I'm done walking." These people are furious at the high cost of health care, so they blame illegals, who don't even get health care. News flash, Glenn Beck fans: the reason health care is so expensive is because you're all so unhealthy.
Yes, it was fun this week to watch the teabaggers complain how the media underestimated the size of their march, "How can you say there were only 60,000 of us? We filled the entire mall!" Yes, because you're fat. One whale fills the tank at Sea World, that doesn't make it a crowd.
President Obama has identified all the problems with the health care system, but there's one tiny issue he refuses to tackle, and that's our actual health. And since Americans can only be prodded into doing something with money, we need to tax crappy foods that make us sick like we do with cigarettes, and alcohol -- and alcohol actually serves a useful function in society in that it enables unattractive people to get laid, which is more than you can say for Skittles.
I'm not saying tax all soda, but certainly any single serving of soda larger than a baby is not unreasonable. If you don't know whether you burp it or it burps you, that's too big. We need to make taking care of ourselves an issue of patriotism. If you were someone who condemned Bush for not asking Americans to sacrifice for the war on terror, the same must be said for Obama and health care. President Arugula is not gonna tell Americans they're fat and lazy. No sin tax on food on Obama's watch.
And at a time when it's important to set new standards for personal responsibility, he appointed a surgeon general, who is, I'm sorry, kind of fat. Certainly too heavy to be a surgeon general, it's a role model thing. It would be like appointing a Secretary of the Treasury who didn't pay his taxes. He did?
And get this: Surgeon General Benjamin had previously been a nutritional advisor to Burger King. The only advice a "health expert" should give Burger King is to stop selling food. The "nutritional advisor" job was described as, "promoting balanced diets and active lifestyle choices" -- and who better to do that than the folks who hand you meat and corn syrup through a car window? When you have a surgeon general who comes from Burger King, it's a message to lobbyists, and that message is, "Have it your way."
Japan moves to trim stimulus budget
Japan’s ruling Democratic party on Friday formally decided to suspend elements of the Y15,000bn ($164bn) economic stimulus package being implemented in the world’s second-largest economy. Ministers of the new government, which took power on Wednesday, agreed to start a review of parts of the package, which the defeated Liberal Democratic party administration said was vital to restoring the recession-battered economy to health. In the DPJ’s view, it contains much wasteful and ill-considered spending.
In an interview with the FT before his appointment as finance minister, Hirohisa Fujii, targeted categories of stimulus spending worth more than Y7,000bn for “substantial cuts”. Mr Fujii told journalists on Friday savings could amount to “several trillion” yen and government ministers should identify elements of the package to scrap by October 2. He believes there are three main options for using the money saved: reducing Japan’s worrying debt burden by cutting bond issuance; beefing up the more positive elements of the package; and putting the money aside to use in the fiscal year from next April to help finance DPJ manifesto promises.
Ahead of his appointment, Mr Fujii had said he favoured the third option, given the importance of finding funds for expensive election pledges such as the introduction of generous child allowances, free public schooling and tax cuts on petrol and cars. However, Mr Fujii and senior DPJ colleagues will be watching closely the performance of Japan’s economy in the next few months, amid widespread concerns about the resilience of the recovery.
Some economists warn that shutting off the stimulative spending tap too rapidly could plunge the economy back into recession, and that would be blamed on the new government, the first to be led by a majority party other than the LDP since 1955. Though Mr Fujii is seen as a fiscal conservative, he has stressed that action to reduce Japan’s budget deficit and debt overhang will not be taken at the expense of current economic growth. The Nikkei 225 average dropped 1 per cent on Friday.
What We Can Learn as Japan's Economy Sinks
by Andy Xie
Japan has had a political earthquake. The Liberal Democratic Party (LDP) that ruled Japan since the end of the World War II lost most of its seats in the latest election, while the Democratic Party of Japan (DPJ) won 308 of 480 lower house seats, complementing its majority in the upper house. Now, DPJ is in a strong position to undertake structural reforms. Indeed, a big political change brings hope in any country that's stagnated for as long as Japan. However, DPJ is unlikely to turn around Japan's economy anytime soon. LDP, in the name of Keynesian stimulus, spent all its money over the past decade on wasteful investments, leaving DPJ with no resources for reform. I'm afraid DPJ has an impossible situation on its hands.
Anyone who doesn't believe in the harm of a financial bubble but does believe in Keynesian stimulus magic should visit Japan. A likely dip for the Anglo-Saxon economies next year will underscore these truths. The same goes for anyone who thinks China's latest real estate bubble, asset borrowing and shadow banking system are worthwhile substitutes for real economic growth. The world including China can learn a lot by looking at what's happened to Japan, and what's in store for DPJ. Since Japan's stock market bubble burst in 1989 and the land market popped in 1992, the LDP government has run up debt equal to nearly 200 percent GDP in hopes of reviving the economy. And its economy has stagnated.
The burst of the global credit bubble in 2008 brought down Japan's export machine. That was its only hope. Now, of all OECD economies, Japan's looks most like a depression. Its nominal GDP declined 8 percent in the first quarter 2009 from the year before. Although its economy rebounded a bit in the second quarter, nominal GDP for 2009 is still expected to decline substantially and will likely be lower than in 1993.
Many analysts blame Japan's problems on corporate inefficiency. This is partly true. Japan has had a hyper-competitive export sector. Domestic, demand-oriented industries are inefficient due to labor market practices. More importantly, sectors that became massively levered during the bubble years have been walking like zombies for two decades, weighing down the economy's overall efficiency. Japan's inefficiencies are largely a consequence of its decision to prop these industries.
U.S. return on asset (ROA) was twice as high as that in Japan. But, in hindsight, higher ROA in the United States was mostly a bubble phenomenon. Much of U.S. corporate profitability was due to financial engineering. In one aspect, the export performance of Japan's corporate sector has done very well -- much better than its U.S. counterpart. Japan's exports doubled in yen terms between 1993 and 2008, and the sector's share of GDP nearly doubled to 16 percent from 9 percent, even though the yen remained strong during the period. The performance of Japan's export sector shows its inefficiencies elsewhere were largely due to shortcomings in the system.
Japan's stagnation has been linked to government handling of debt overhang in the corporate sector -- mainly in the real estate, construction, and retail sectors, and left over from the bubble era. In the 1980s, especially after the Plaza Accord, Japan's corporate sector accumulated a massive amount of debt for financial speculation. Total corporate debt more than doubled to about 900 trillion yen, or 200 percent of GDP, from 1984-'92. After land and stock prices collapsed, the net value of the corporate sector's financial assets switched from about 30 percent of GDP to a minus 50 percent of GDP. If the change in land holding value is included, the corporate sector's net worth may have fallen by 200 percent of GDP. As corporate profits are about 10 percent of GDP in a developed economy, Japan's corporate sector would need two decades to earn its way back.
The Japanese government did choose to let the corporate sector earn its way back, first by preventing bankruptcies and second by stimulating demand. To achieve the first goal, the government kept interest rates near zero and Japanese banks did not pursue mark-to-market accounting in assessing borrower solvency. With a big chunk of the corporate sector zombie-like, the economy, of course, was always facing downward pressure. The government had to run large fiscal deficits to prop up the economy. After the bubble, Japan's economic equilibrium stagnated and the fiscal deficit swelled.
This strategy was flawed in three aspects. First, even as the corporate sector earns profits to pay down debt, the government's debt is rising. At best, it is shifting corporate debt to government debt. In reality, government debt has been rising faster than private sector debt has been falling. Second, economic efficiencies don't increase in such equilibrium. Existing resources in the zombie sector are essentially unproductive. Bankruptcies improve efficiency by shifting resources from failing to succeeding companies. When rules are changed to stop bankruptcies, efficiency is sacrificed. Worse, incremental resources are sucked up to pay fiscal deficits used to prop up zombie industries. Japan is thus trapped in equilibrium of low productivity.
Third, a long period of stagnation could worsen irreversible social change. A falling birth rate, for example, is one consequence that is wreaking havoc on the Japanese economy. Japan's post-bubble policy was to let property prices decline gradually. Hence, living costs also declined gradually. On the other hand, the economy stopped growing, which caused income expectations to quickly adjust downward. The combination of high property prices and low income growth rapidly pushed down Japan's birth rate. As a consequence, Japan's population is declining two decades after the bubble. The rising burden of caring for the old will lower Japan's ability to pay for anything else.
After two decades, Japan hasn't achieved its main policy goal by letting its corporate sector work down debt. Total, non-financial corporate debt is about the same as it was two decades ago. At 180 percent of GDP, Japan's corporate indebtedness remains one of the highest in the world. Japan's household sector has indeed de-levered. Its debt at 69 percent of GDP is one of the lowest among developed economies. But government debt has increased massively over the past two decades. Its current debt level at 194 percent is the highest in the world. Only super-low interest rates are hiding the debt burden.
DPJ has been handed a poisoned chalice. It won't have the resources needed for a serious restructuring of the economy. Its twin goals are to increase support for the household sector and shift decision-making power to politicians from bureaucrats. The government's debt burden makes it impossible for any meaningful increase in supporting the household sector. LDP wasted all the money. DPJ has no room to finance either new social programs or economic restructuring. To show progress, DPJ is likely to stage a high-profile confrontation with the bureaucracy – a step that may be good for politics but won't do much to improve the economy.
Total indebtedness of Japan's non-financial sector is 443 percent -- probably the highest in the world, and far higher than the 240 percent in the United States. A difference is that the United States owes a big chunk of its debt to foreigners, while all of Japan's is carried by its own citizens. Most analysts think high government debt is bearable as long as a country has enough domestic savings to fund it – a situation Japan has enjoyed. But the future may be different. Japan's declining labor force is decreasing its export ability. At some point, it may begin to run trade and current account deficits. When that happens, Japan's interest rate may rise substantially, which would cause a fiscal crisis. Such a crisis may occur under the DPJ's rule. It could be blamed for a crisis that LDP had been building for two decades.
We can learn much from Japan's experience. The global economy -- mainly the Anglo-Saxon economy -- is facing the consequences of a massive credit bubble. The remedies most governments have embraced are to keep interest rates low and fiscal deficits high. These are the same policies Japan pursued after its bubble burst nearly two decades ago. How today's bubble economies are treating bankruptcies and bad debt is shockingly similar to what was seen in Japan. The United States and others have suspended mark-to-market accounting rules to let banks stay afloat despite large amounts of toxic assets. It's the same "let them earn their way back" strategy that Japan pursued. The strategy fails to work because it keeps an economy weak, limiting the earning power of financial institutions.
As the global economy is again showing signs of growth in the third quarter, most governments are celebrating the effectiveness of their policies. Yet Japan's experience forces us to pause: Its economy experienced many such growth bounces over the past two decades, but was unable to sustain any of them. The problem was Japan only used stimulus, not restructuring, to cope with the bursting of its bubble. After the demise of any big bubble, serious structural problems that hamper economic growth remain. Stimulus can only provide short-term support that makes structural reform possible. When policymakers celebrate the short-term impact of stimulus and forget structural reforms, economies slump again. I think the Anglo-Saxon economies will dip again next year.
China can learn a lot from Japan's experience as well. Its bubble formed when companies began focusing on financial investments rather than core business. In the 1980s, Japan's corporate sector tapped the corporate bond market and raised massive amounts of capital for asset purchases. Recently, Chinese enterprises borrowed money and pumped it into asset markets. They essentially provided leverage for asset markets. When leverage was rising, asset inflation occurred, letting companies book profits that were many times greater than operating profits from core businesses. That gave them greater incentive to pursue asset appreciation rather than operating profitability. The corporate sector became a shadow banking system for financing asset speculation.
Thus, China's corporate sector is now behaving in a way similar to what was seen in Japan two decades ago. China's businesses increasingly focus on asset investment rather than core business. When an asset bubble boosts corporate profits, it seems benign at first. Nobody sees the harm. However, when businesses earn profits from the investments in each other rather than their corporate businesses, their operating profitability deteriorates because they don't invest in their core businesses anymore. Accounting profitability is just a bubble.
As I traveled across China recently, it was rare to hear about a business whose officials are enthusiastic about their core business. But everyone seems excited about financial activities. The lending boom in the first half of 2009 seems to have been channeled mostly into asset markets by the corporate sector. In particular, property seems to have become a main profit source for most big businesses. China's corporate borrowing one way or another goes into the land market. And property development has become the most important source of profit for China's corporate sector. If a manufacturing business is buoyant, odds are it is profiting from property development. The banking sector reports high profitability due to direct or indirect loans for property development. Property development profit is actually from land appreciation. If property development profitability is measured according to land price at sale time, the development itself would not be profitable.
A bubble rises when there is excess money supply. Is the current, excessive monetary growth due to demand or supply? We can argue that point forever. When the former chairman of the U.S. Federal Reserve, Alan Greenspan, said a central bank couldn't stop a bubble, he meant money demand would rise regardless of interest rates. I disagree. If a central bank targets monetary growth in line with nominal GDP growth, a big bubble can't happen. Aside from central bank failure, then, the most important microeconomic element in a bubble is the shadow banking system.
Regulators limit what banks can do by imposing capital requirements. The international standard is 8 percent of total assets, but banks can use accounting tricks to minimize their requirements. But a big accounting loophole can lead to disaster. For example, the loose restrictions on off-balance holdings were major factors in the global credit bubble. Most regulators are now tightening accounting rules for capital requirements. Shadow banking is a less noticed but more important factor in creating bubbles. Most analysts compare it to the hedge fund industry, which provided leverage for financial speculators with little capital. The shadow banking system is much more because industrial firms engaging in financial activities are more important. Entities such as GE Capital and GMAC provided massive leverage to asset markets with little capital. A shadow banking system is essential to a big bubble.
China's corporate sector increasingly looks like a shadow banking system. It raises funds from banks, through commercial bills or the corporate bond market, and then channels the funds into the land market. The resulting land inflation underwrites corporate profitability and improves their creditworthiness in the short term. The same thing happened in Japan. To control China's expanding real estate bubble, the country's regulators must limit monetary growth to nominal GDP growth. Faster monetary growth accommodates and supports the bubble. To understand consequences of ignoring this reality, we need only look at Japan today.
Jim Grant: Ringing the Bell at the Top?
by Michael Panzner
In the following Wall Street Journal commentary, "From Bear to Bull," a long-time critic of the excesses and wayward policies that brought this country to its knees suggests the outlook for the economy is brighter than many people, especially the pessimists, believe:James Grant argues the latest gloomy forecasts ignore an important lesson of history: The deeper the slump, the zippier the recovery.
As if they really knew, leading economists predict that recovery from our Great Recession will be plodding, gray and jobless. But they don't know, and can't. The future is unfathomable. Not famously a glass half-full kind of fellow, I am about to propose that the recovery will be a bit of a barn burner. Not that I can really know, either, the future being what it is. However, though I can't predict, I can guess. No, not "guess." Let us say infer.
The very best investors don't even try to forecast the future. Rather, they seize such opportunities as the present affords them. Henry Singleton, chief executive officer of Teledyne Inc. from the 1960s through the 1980s, was one of these enlightened opportunists. The best plan, he believed, was no plan. Better to approach an uncertain world with an open mind. "I know a lot of people have very strong and definite plans that they've worked out on all kinds of things," Singleton once remarked at a Teledyne annual meeting, "but we're subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible." Then how many influences, outside and inside, must bear on the U.S. economy?
Though we can't see into the future, we can observe how people are preparing to meet it. Depleted inventories, bloated jobless rolls and rock-bottom interest rates suggest that people are preparing for to meet it from the inside of a bomb shelter.
The Great Recession destroyed confidence as much as it did jobs and wealth. Here was a slump out of central casting. From the peak, inflation-adjusted gross domestic product has fallen by 3.9%. The meek and mild downturns of 1990-91 and 2001 (each, coincidentally, just eight months long, hardly worth the bother), brought losses to the real GDP of just 1.4% and 0.3%, respectively. The recession that sunk its hooks into the U.S. economy in the fourth quarter of 2007 has set unwanted records in such vital statistical categories as manufacturing and trade inventories (the steepest decline since 1949), capacity utilization (lowest since at least 1967) and industrial production (sharpest fall since 1946).
It isn't just every postwar disturbance that sends Citigroup Inc. (founded in 1812) into the arms of the state or has General Electric Co. (triple-A rated from 1956 to just this past March) borrowing under the wing of the Federal Deposit Insurance Corp. Neither does every recession feature zero percent Treasury bill yields, a coast-to-coast bear market in residential real estate or a Federal Reserve balance sheet beginning to resemble that of the Reserve Bank of Zimbabwe. Yet these things have come to pass.
Americans are blessedly out of practice at bearing up under economic adversity. Individuals take their knocks, always, as do companies and communities. But it has been a generation since a business cycle downturn exacted the collective pain that this one has done. Knocked for a loop, we forget a truism. With regard to the recession that precedes the recovery, worse is subsequently better. The deeper the slump, the zippier the recovery. To quote a dissenter from the forecasting consensus, Michael T. Darda, chief economist of MKM Partners, Greenwich, Conn.: "[T]he most important determinant of the strength of an economy recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-1939 period."
Growth snapped back following the depressions of 1893-94, 1907-08, 1920-21 and 1929-33. If ugly downturns made for torpid recoveries, as today's economists suggest, the economic history of this country would have to be rewritten. Amity Shlaes, in her "The Forgotten Man," a history of the Depression, shows what the New Deal failed to achieve in the way of long-term economic stimulus. However, in the first full year of the administration of Franklin D. Roosevelt (and the first full year of recovery from the Great Depression), inflation-adjusted gross national product spurted by 17.3%. Many were caught short. Among his first acts in office, Roosevelt had closed the banks. He had excoriated the bankers, devalued the dollar, called in the people's gold and instituted, through the National Industrial Recovery Act, a program of coerced reflation.
"At the business trough in 1933," Mr. Darda points out, "the unemployment rate stood at 25% (if there had been a 'U6' version of labor underutilization then, it likely would have been about 44% vs. 16.8% today. . . ). At the same time, the consumption share of GDP was above 80% in 1933 and the household savings rate was negative. Yet, in the four years that followed, the economy expanded at a 9.5% annual average rate while the unemployment rate dropped 10.6 percentage points." Not even this mighty leap restored the 27% of 1929 GNP that the Depression had devoured. But the economy's lurch to the upside in the politically inhospitable mid-1930s should serve to blunt the force of the line of argument that the 2009-10 recovery is doomed because private enterprise is no longer practiced in the 50 states.
To the English economist Arthur C. Pigou is credited a bon mot that exactly frames the issue. "The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant." So it is today. Paul A. Volcker, Warren Buffett, Ben S. Bernanke and economists too numerous to mention are on record talking down the recovery before it fairly gets started. They collectively paint the picture of an economy that got drunk, fell down a flight of stairs, broke a leg and deserves to be lying flat on its back in the hospital contemplating the wages of sin. Among economists polled by Bloomberg News, the median 2010 GDP forecast is for 2.4% growth. It would be a unusually flat rebound from a full-bodied downturn.
Our recession, though a mere inconvenience compared to some of the cyclical snows of yesteryear, does bear comparison with the slump of 1981-82. In the worst quarter of that contraction, the first three months of 1982, real GDP shrank at an annual rate of 6.4%, matching the steepest drop of the current recession, which was registered in the first quarter of 2009. Yet the Reagan recovery, starting in the first quarter of 1983, rushed along at quarterly growth rates (expressed as annual rates of change) over the next six quarters of 5.1%, 9.3%, 8.1%, 8.5%, 8.0% and 7.1%. Not until the third quarter of 1984 did real quarterly GDP growth drop below 5%.
One may observe that Ronald Reagan stood for enterprise, free trade and low taxes, whereas Barack Obama stands for other things. Yet President Obama's economic policies seem almost as far removed from Roosevelt's as they are from Reagan's. (Not for Obama, at least not yet, is a new National Recovery Administration). Certainly, Roosevelt never attempted anything like the fiscal and monetary resuscitation organized over the past 12 months.
In the post World War II era, the government has attacked recessions with an average fiscal stimulus of 2.6% of GDP and an average monetary stimulus of 0.3% of GDP, for a combined countercyclical lift of 2.9%. (Fiscal stimulus I define as the cumulative change in the federal budget, monetary stimulus as the cumulative change in the Fed's balance sheet, both measured from the peak of the boom to the trough of the bust.) This time out, the fiscal stimulus is likely to measure 10% of GDP, monetary stimulus 9.5% of GDP, for a combined pick-me-up equivalent to 19.5% of GDP. Our Great Recession would be marked for greatness if for no other reason than by the outpouring of federal dollars to repress it.
What did we do before Timothy Geithner and Ben Bernanke? In the day, it was the self-regenerative power of markets that lifted us off the rocks. The brutality of the depression of the early 1920s could not have been far from the mind of President Harry S. Truman as he signed into law the 1946 act to make it the government's business to maintain the economy at full employment. That 1920-21 crackup featured a deflationary collapse—wholesale prices plunged by 37%—and, by 21st century lights, a highly unconventional set of government measures to set things right. To meet the downturn, the Fed raised, not lowered, interest rates and Congress balanced the budget—indeed, ran a surplus.
Yet the depression ended. How, exactly, did it end? Falling prices opened wallets, the monetary historian Allan H. Meltzer explains. Finding bargains, consumers and investors snapped them up. "The fall in market prices raised the public's stock of real [money] balances above the desired amount, just as if the Federal Reserve had increased base money at a constant price level," Mr. Meltzer relates in his "A History of the Federal Reserve." After falling by 4.4% in 1920 and by 8.7% in 1921, inflation-adjusted GNP shot up by 15.8% in 1922 and by 12.1% in 1923.
Bargain-hunting is the balm of recovery even today, dead set against low prices the Federal Reserve might be. Detroit is a living laboratory in many things, including the so-called real balance effect. As Marshall Mandall, a RE/MAX agent in that city, tells the story, house prices are still falling at the high end of the market, though they have stabilized at the low end. Transaction volumes are rising. Speculators are on the prowl, but so, too, are ordinary home buyers. It seems—who'd have guessed it?—that value sells. "They can buy something for half of what they could three years ago," Mr. Mandall says. "Everybody perceives bargains in their house-hunting." At the end of the second quarter, according to the Detroit Free Press, the supply of unsold houses was equivalent to 8.5 months' sales, down 39% from the year before.
Through the first six months of 2009, the Case-Shiller 10-City Composite index of house prices fell by 5.5% compared to year-end 2008. However, the rate of decline has been slowing and, indeed, the index recorded month-to-month appreciation in May and June. It may just be that the Fed's assumption of a 14% decline in prices this year (built into the base case of its bank stress test) is unrealistically bearish.
The Fed's voice is among the saddest in the lugubrious choir of bearish forecasters, and for good reason. By instigating a debt boom, the Bank of Bernanke (and of his predecessor, Alan Greenspan) was instrumental in causing our troubles. You might have thought that it would therefore see them coming. Not at all. Belatedly grasping how bad was bad, it has thrown the kitchen sink at them. And it maintains this stance of radical ease lest it get the blame for a relapse. However, by driving money market interest rates to zero and by setting all-time American records in money-printing ($1.2 trillion conjured in the past 12 months), the Fed is putting the value of the dollar at risk. Its wide-open policy all but begs our foreign creditors to ask the fatal question, What is the dollar, anyway? Why, the dollar is a scrap of paper, or an electronic impulse, the value of which is anchored by the analytical acuity of the monetary bureaucracy that failed to predict the greatest financial crackup since the 1930s.
The Fed may be worried about something else. By sitting on interest rates, it is distorting every business and investment decision. If mispriced debt was the root cause of the narrowly-averted destruction of global finance, the Fed is well on its way to setting the stage for some distant (let us hope) Act II. In the meantime, ultra-low interest rates have lit a fire under the stock and debt markets.
By rallying, equities and corporate bonds not only anticipate recovery, but they also help to bring it to fruition. By opening their arms wide to such previously unfinanceable businesses as AMR Corp., parent of American Airlines, and Delta Air Lines Inc., the newly confident credit markets are implementing their own stimulus program. "Reflexivity" is the three-dollar word coined by the speculator George Soros to describe the dual effect of market oscillations. Not only does the rise and fall of the averages reflect economic reality, but it also changes it. One year ago, the Wall Street liquidation stopped world commerce in its tracks. Today's bull markets are helping to revive it.
I promised to be bullish , and I am (for once)—bullish on the prospects for unscripted strength in business activity. So, too, is the Economic Cycle Research Institute, New York, which was founded by the late Geoffrey Moore and can trace its intellectual heritage back to the great business-cycle theorist Wesley C. Mitchell. The institute's long leading index of the U.S. economy, along with supporting sub-indices, are making 26-year highs and point to the strongest bounce-back since 1983. A second nonconformist, the previously cited Mr. Darda, notes that the last time a recession ravaged the labor market as badly as this one has, the years were 1957-58 —after which, payrolls climbed by a hefty 4.5% in the first year of an ensuing 24-month expansion. Which is not to say, he cautions, that growth this time will match that pace, only that growth is likely to surprise by its strength, not weakness.
And that is my case, too. The world is positioned for disappointment. But, in economic and financial matters, the world rarely gets what it expects. Pigou had humanity's number. The "error of pessimism" is born the size of a full-grown man—the size of the average adult economist, for example.
James Grant is the editor of Grant's Interest Rate Observer. Among his books is "The Trouble with Prosperity."
To be sure, Mr. Grant rightfully acknowledges the folly of economic forecasting and is careful about pinpointing when we might expect to see his anticipated strong recovery. Yet by citing the work of the Economic Cycle Research Institute, which has recently been suggesting that a major upswing is on the cards, Mr. Grant seems to make it clear that now is the time for optimism. Unfortunately, his rationale is weak, if not totally wrong. For the most part, his argument rests on the premise that, historically at least, strong recoveries have followed severe contractions.
Aside from discounting the fact that there are aspects to the current unraveling that are historically unique and extraordinarily unsettling (e.g., total credit market debt relative to gross domestic product is well beyond anything this country has ever witnessed), Mr. Grant makes a number of curious assertions. For one thing, he assumes that the current downturn is near its nadir, instead of a temporary floor built on a massive stimulus injection and a knee-jerk bout of inventory restocking. Among logicians, such an analytical approach might be described as "begging the question."
Mr. Grant also gives short shrift to the fact that in many ways -- see "A Tale of Two Depressions" by Barry Eichengreen and Kevin H. O'Rourke for more on this subject -- the economic episode that most closely parallels the current downturn is the one that occurred during the Great Depression, which lasted twice as long as the latest one has.
Perhaps our economy will rebound sharply in 2011, but from what level? Should we really be preparing for the best right now -- instead of the worst -- given how many icebergs --like the accelerating meltdown in commercial real estate and the mortgage reset timebomb -- are only just floating into view?
History suggests that time is not on the side of the optimists when it comes to episodes like the one we are going through. As I'm sure Mr. Grant is aware, Professors Carmen M. Reinhart and Kenneth S. Rogoff have published a research paper, "The Aftermath of Financial Crises," based on data going back more than a century, which concluded that post-crisis downturns tend to be "protracted affairs."
To bolster his allegedly contrarian argument, Mr. Grant points to the swollen ranks of pessimists preparing to meet the future from "inside of a bomb shelter." But after decades of bubble-induced euphoria and an economy built on massive debt and unparalleled overconsumption, I wonder if he is engaging in a bit of dot-com era relativism -- where the Nasdaq was "cheap" at 4,000 because it was down 20 percent from its peak (it is now 2,132).
If savings rates, debt levels, and the share of the U.S. economy accounted for by consumer spending were to return to, say, pre-Greenspan era norms, then one bomb shelter might not be enough to handle the economic onslaught that is still headed our way. Finally, Mr. Grant makes the cardinal error of many ivory tower economists. He credits equity investors with the wisdom of crowds. Those are the same people who bid share prices to new all-time highs in the fall of 2007, just as credit markets were unraveling, home prices were collapsing, and the bottom was falling out of the real economy. Hmmm.
That said, it is certainly not my intention to lump Jim Grant with all those clueless strategists, economists, and policymakers who failed to see things coming. In fact, I think he is a very smart guy and I've always enjoyed hearing what he has to say. But the fact is that bull and bear markets frequently have one thing in common: turning points marked by the public capitulation of one or more prominent contrarians. Given what Mr. Grant has just written, I can only ask: Did one of the world's best known bears just ring the bell at the top of the great dead cat bounce?
The Neverending Depression
Steve Keen explains to Max Keiser why deflation is well on its way
The U.S. Balance Sheet: Households See Net Worth Down by $12 Trillion Since Peak and Total Debt Floating in the Market of $33 Trillion
The Federal Flow of Funds report was released on Thursday with an expected jump in household net worth. When we did our last report, we stated that with the $13.89 trillion in wealth that evaporated to the trough, we would expect a jump in net worth to come from the massive stock market rally. The report shows this paper wealth gain that started at the end of Q1. Household net worth increased by $2 trillion from the first quarter to the end of the second quarter of 2009. Much of the increase came from the $1.36 trillion increase in corporate equities and mutual funds. Real estate grew by $139 billion. Yet this increase is merely a reflection of all the liquidity being flushed into the equity markets by the Federal Reserve.
Below is a chart of household net worth:
Keep in mind that American households are still down by $12 trillion from the peak reached in 2007. This quarterly move would be more significant if unemployment and government funds were less of a short-term mover. If anything, what this report tells us is that the only thing that is rallying from the bottom is equities. It is gathering massive steam and price/earnings ratios are not being reflected in the real world.
What we see in the current report is merely the reflection of the 60 percent stock market rally. From April to June, the market rallied significantly:
Since then, the third quarter has also seen another increase in the trend upward. So we should expect that when the Q3 report is released that household net worth will increase again driven by equities again. As you can tell, real estate is no longer the driving force even though it is the largest line item for U.S. households.
Current U.S. household net worth: $53 trillion
U.S. household real estate: $20 trillion
So real estate makes up nearly 40 percent of household net worth. Keep in mind that $20 trillion in real estate is secured by $10.4 trillion in mortgages many that are now going bad. Interestingly enough, if you look at the mortgage data it peaks around $10.54 trillion and has fallen to $10.4 trillion. Do we really think that only a few hundred billion in mortgages have gone bad? This is simply a reflection of banks not writing down option ARMs and other questionable assets.
The commercial real estate debt is going to hit and cause more losses in the years to come. Yet this is part of the trend that we will not be seeing in the Q3 report. And if you really want to see something frightening in the report, just look at total debt outstanding:
If you add it up, American households have $13.74 trillion in debt. But look at what American business have in debt. That is another $11.2 trillion and you can rest assured much of that commercial real estate is sitting there. State and local governments are saddled with $2.2 trillion in debt and we all know how tough things are for state governments. Unlike the Federal government, states do not have access to the printing press known as the U.S. Treasury so they have to operate in a financial reality that the Federal government seems to ignore.
The debt is coming out of everywhere. Much of this debt is secured by real estate and commercial properties that are still being valued at peak prices. Stocks reflect optimistic scenarios. So we will see another leg down in 2010 possibly as early as Q4 of 2009 since we are starting to see already some weakness of the $13 trillion in financial bailouts and backstops.
And if anyone thinks that we will ever payoff some $33 trillion in debt they are out of their minds. I’ll let you run the math on that one so you can see how laughable this is. Think about it. If our GDP is $14 trillion or so, it would take us over 2 years of full U.S. productivity to pay off this debt. That will never happen because we are spending along the way. This is like a household making $30,000 a year needing to pay off a $3 million loan. As long as the monthly payment is low, not a big deal right? But we’ll be paying this stuff off for centuries.
BlackRock’s Fink Says Obama Rules Threaten Markets
BlackRock Inc. Chairman Laurence Fink said Obama administration programs to help homeowners stave off foreclosure may hinder the recovery of the mortgage market while benefiting banks that own second loans on the properties. “I am just very worried,” Fink said yesterday in an interview in New York. “How do we get a vibrant securitization market back when we are doing these things in the short run that are good for the banking system and good for the homeowner but not as good as it should be?”
Fink said policies introduced this year to reduce foreclosures are flawed because they don’t require home-equity loans to be wiped out before the mortgage is modified. Instead, in a break with the intentions of contracts, the second loan’s terms may also be revised, spreading the financial loss among lenders, he said. At stake is the recovery in the market for securities created from individual loans, including the almost $1.7 trillion in residential-mortgage bonds not backed by the U.S., according to Fink. Federal Reserve Chairman Ben S. Bernanke said in April the securitization market was “until recently” an important source of credit for the U.S. economy.
“This to me is one of the biggest issues facing American capitalism,” Fink said. “There is modification going on protecting our banks, protecting their balance sheets.” With the right types of changes, he added, “the homeowner is better off, America is better off, and you could say the first lien holder is better off.”
Fink, who as a First Boston Corp. executive in the 1980s helped create securities known as collateralized-mortgage obligations, will lead the world’s biggest money manager when BlackRock completes its acquisition of Barclays Global Investors later this year. The New York-based company, which will oversee about $3 trillion, has emerged as a top adviser on distressed securities to governments and financial institutions since the credit crisis started in 2007.
Fink, who also serves as BlackRock’s chief executive officer, is the highest-profile investor to call attention to potential conflicts when banks that service mortgages handle loan modifications. One concern is that many servicers, which handle billing and collection for mortgage owners, also hold home-equity loans that would lose all value in a foreclosure. JPMorgan Chase & Co., Bank of America Corp., Wells Fargo & Co. and Citigroup Inc., the four largest servicers, own almost $450 billion of home-equity loans, according to Laurie Goodman, an analyst at Amherst Securities Group in New York.
“I am glad that a firm such as BlackRock believes these conflicts are serious and the lack of resolution has profound implications on the financial markets and our country,” Bill Frey, head of Greenwich Financial Services LLC, a mortgage-bond broker and investor in Greenwich, Connecticut, said in an interview yesterday. “We have been working with a number of very large financial institutions and many hold the view.” Frey is suing Bank of America over modifications the bank agreed to make to settle charges of fraudulent lending by state attorneys general against Countrywide Financial Corp., which it bought last year. He said the investors he is working with want “to devise strategies to enforce their contractual rights.” He declined to identify the firms or their potential tactics.
President Barack Obama’s $75 billion Making Home Affordable plan provides taxpayer subsidies to encourage loan servicers to rework borrowers’ first mortgages to cut their monthly payments to 31 percent of their incomes. Provisions for second mortgages weren’t immediately released. Obama later signed a law giving servicers safe harbor from investor lawsuits when they modify debt using the program. The Treasury Department, responding to complaints from investors, said in April that when first mortgages are modified, participating banks with second liens would also have to revise terms. A department official said in July it hadn’t completed contracts with such requirements, and some banks said they might not sign them.
Meg Reilly, a Treasury spokeswoman, declined to comment. Officials at New York-based JPMorgan, Wells Fargo in San Francisco, and Citigroup in New York either didn’t immediately comment or return messages. “Bank of America is committed to helping homeowners who need a modification, whether it is a first mortgage or home- equity loan,” Terry H. Francisco, a spokesman for the Charlotte, North Carolina-based company, said in an e-mail. “We believe the soon-to-be-unveiled second lien MHA program will help provide the structure necessary to accomplish more second lien modifications on a uniform basis.”
Bond investors would prefer that more homeowners had loan balances reduced rather than payment terms eased, Curtis Glovier, a managing director at New York-based Fortress Investment Group LLC, told Congress in July. Such aid for consumers whose debt is greater than the value of their homes is being blocked because other loan changes allow second mortgages to be kept “on the books of the financial institution as a performing asset,” he said. Fink co-founded BlackRock as a bond manager in a one-room Manhattan office in 1988. He supported Obama’s presidential election.
Bernanke has been working to revive securitization. The Fed’s Term Asset-Backed Securities Loan Facility, a program under which the central bank lends to buyers of asset-backed debt, “has shown early success in reducing risk spreads and stimulating securitization activity,” he said on Aug. 21. The program has helped create demand this year for $124 billion of new securities backed by debt such as automobile leases, credit cards and small-equipment loans. No private securities have been created out of new commercial or residential mortgages since early 2008.
A record $1.2 trillion of home-loan bonds not guaranteed by government-supported Fannie Mae and Freddie Mac, or U.S. agency Ginnie Mae, was issued in 2005 and 2006. Sales of commercial mortgage-backed securities peaked in 2007 at $237 billion. The dispute over loan modifications echoes complaints by institutional investors that Obama’s handling of Chrysler LLC’s bankruptcy benefited unsecured creditors including unionized workers at the expense of secured lenders. “If you really want to protect the homeowner, wipe out the second lien, modify the first lien,” Fink said.
Last Chance for Justice
by Michael Hirsh
The new Financial Crisis Inquiry Commission may be the only opportunity to nail Wall Street.
As he ushered in a new era in Washington, Franklin D. Roosevelt's theme song was "Happy Days Are Here Again," but people tend to forget that along with sunny optimism FDR delivered a strong dose of justice. He left that job to Ferdinand Pecora, a fierce New York prosecutor whom Roosevelt urged to investigate Wall Street's perniciousness. Pecora delivered big time. He humiliated and forced the resignation of Charles Mitchell, the head of National City Bank (later Citibank), and oversaw a 12,000-page probe into the causes of the Great Depression that gave birth to a new regulatory framework, including the Securities and Exchange Commission (Pecora was later one of the first commissioners). Other Wall Streeters were prosecuted, convicted, and jailed. The theme song to our current era might be, more appropriately, “(I Can’t Get No) Satisfaction.”
Two years into the revelation that Wall Street was playing a giant confidence game with the world, disguising bad and often fraudulent mortgages as highly rated securities, selling scam derivatives by the trillions, there have been no major prosecutions. Afloat in taxpayer bailouts and the giant bonuses they're awarding themselves once again, Wall Streeters are back to being their feisty selves. No executive has gone to jail. The only ones who've resigned are those who had no choice because their companies disappeared (James Cayne of Bear Stearns, Dick Fuld of Lehman, John Thain of Merrill Lynch) or who were shown to be such astonishing incompetents that their boards had no choice but to can them (Stanley O'Neal of Merrill, Chuck Prince of Citigroup).
The handful of prosecutions on the horizon are not promising: the trial of former Bear Stearns hedge-fund managers Ralph Cioffi and Matthew Tannin starts in mid-October, but their lawyers are confident they can show that the duo was simply foolish, not criminal. A grand jury has been convened to look into the behavior of Joseph Cassano, the former AIG executive who sold $500 billion worth of credit-default swaps without hedging them. But Cassano will no doubt argue the same thing: "I was just a moron." It will be hard for any jury to disagree.
So the public may have just one chance left for satisfaction: Congress's Financial Crisis Inquiry Commission, which started work Thursday. The early signs are, however, not terribly promising. The commission's chairman, Phil Angelides, is no Ferdinand Pecora, though he claims to keep Pecora's book next to his bed. Angelides is a crony of Nancy Pelosi and a California politician who, as state treasurer, was known as a mild reformer. While he enjoys subpoena power as Pecora did (and as the last famous Washington blue-ribbon panel, the 9/11 Commission, did not), Angelides says he's not eager to use it; he prefers "voluntary" cooperation.
Beyond that, despite the presence of a few standouts like Brooksley Born, the derivatives whistle-blower from the '90s, the commission is manned with partisans of the left and right who could easily tie themselves—and the investigation—up in ideological knots. Still, Angelides and his team may yet surprise us. It's happened before. The history of "blue ribbon" commissions like this one is rich and storied in Washington; one of them, in 1942, was led by an obscure senator from Missouri who was also seen as a political hack at the time.
His name was Harry Truman, and he turned his commission on defense malfeasance into a ticket into the White House and the history books. It's also not necessarily a bad thing that Angelides is no "Ferd" Pecora. After World War II, some prominent economists found that some of the Pecora Commission's conclusions were too zealous. That was especially true of the charge that the stock market crash was caused by banks that had stuffed their customers' portfolios with securities underwritten by their investment-banking sides (leading to the Glass-Steagall Act, which separated commercial and investment banks). We may need some restraint now along with righteous wrath.
In other words, we don't necessarily need a parade of Wall Streeters headed to the Big House. What we do need, however, is a parade of witnesses who will provide what's been missing so far in this crisis—a prominent outlet for public outrage. In the last nine months, the Obama administration and the grandees in Congress have been designing solutions without much input from the outside, often using experts from Wall Street (especially "Government Sachs"). It's pretty much been a closed system.
Even Paul Volcker, considered perhaps the greatest Federal Reserve chairman in history (now that the Alan Greenspan era looks much worse retrospectively), has been all but ignored by the president he is advising. Volcker has been making a series of speeches around the country calling for sensible changes to the structure of Wall Street that the administration and Congress are not yet considering. He wants federally guaranteed bank deposits to be cordoned off from heavy risk-taking and proprietary trading. Volcker wants banks, in other words, to be barred from behaving like hedge funds. "Extensive participation in the impersonal, transaction-oriented capital market does not seem to me an intrinsic part of commercial banking," Volcker told a corporate group Wednesday in Los Angeles. He should be invited to Washington to say the same thing.
Desperately seeking an exit strategy
There's a general consensus that the massive monetary easing, fiscal stimulus and support of the financial system undertaken by governments and central banks around the world prevented the deep recession of 2008-2009 from devolving into the Second Great Depression. Policy-makers were able to avoid a depression because they had learned from the policy mistakes made during the Great Depression of the 1930s and Japan's near depression of the 1990s. As a result, policy debates have shifted to arguments about what the recovery will look like: V-shaped (rapid return to potential growth), U-shaped (slow and anemic growth) or even W-shaped (a double dip). During the global economic free fall between last fall and this spring, an L-shaped economic and financial Armageddon was still firmly in the mix of plausible scenarios.
But the crucial policy issue ahead is how to time and sequence the exit strategy from this massive monetary and fiscal easing. Clearly, the current fiscal path being pursued in most advanced economies – the reliance of the United States, the euro zone, the United Kingdom, Japan and others on very large budget deficits and rapid accumulation of public debt – is unsustainable. These deficits have been partly monetized by central banks, which, in many countries, have pushed their interest rates down to 0 per cent (in Sweden's case, to below that), and sharply increased the monetary base through unconventional quantitative and credit easing. In the United States, for example, the monetary base more than doubled in a year.
If not reversed, this combination of very loose fiscal and monetary policy will lead to a fiscal crisis and runaway inflation, together with another dangerous asset and credit bubble. So the key issue for policy-makers is to decide when to mop up the excess liquidity and normalize policy rates – and when to raise taxes and cut government spending, and in which combination. The biggest policy risk is that the exit strategy from monetary and fiscal easing is somehow botched, because policy-makers are damned if they do and damned if they don't. If they have built up large, monetized fiscal deficits, they should raise taxes, reduce spending and mop up excess liquidity sooner rather than later.
The problem is that most economies are now barely bottoming out, so reversing the fiscal and monetary stimulus too soon – before private demand has recovered more robustly – could tip these economies back into deflation and recession. Japan made that mistake between 1998 and 2000, just as the United States did between 1937 and 1939. But if governments maintain large budget deficits and continue to monetize them as they have been doing, at some point – after the current deflationary forces become more subdued – bond markets will revolt. When that happens, inflationary expectations will mount, long-term government bond yields will rise, mortgage rates and private market rates will increase, and one would end up with stagflation (inflation and recession).
So how should we square the policy circle? First, different countries have different capacities to sustain public debt, depending on their initial deficit levels, existing debt burden, payment history and policy credibility. Smaller economies – like some in Europe – that have large deficits, growing public debt and banks that are too big to fail and too big to be saved may need fiscal adjustment sooner to avoid failed auctions, rating downgrades and risk of a public-finance crisis.
Second, if policy-makers credibly commit to raise taxes and reduce public spending (especially entitlement spending), say, in 2011 and beyond, when the economic recovery is more resilient, the gain in market confidence would allow a looser fiscal policy to support recovery in the short run.
Third, monetary policy authorities should specify the criteria they will use to decide when to reverse quantitative easing, and when and how fast to normalize policy rates. Even if monetary easing is phased out later rather than sooner – when the recovery is more robust – markets and investors need clarity in advance on the parameters that will determine the timing and speed of the exit. Preventing another asset and credit bubble by including the price of assets such as housing in determining monetary policy is also important.
Getting the exit strategy right is crucial: Serious policy mistakes would significantly heighten the threat of a double-dip recession. Moreover, the risk of such a mistake is high, because the political economy of countries such as the United States may lead officials to postpone tough choices about unsustainable fiscal deficits. In particular, the temptation for governments to use inflation to reduce the real value of public and private debts may become overwhelming. In countries where asking a legislature for tax increases and spending cuts is politically difficult, monetization of deficits and eventual inflation may become the path of least resistance.
UK business lending slumps in July
Figures compound fears that policymakers' efforts to free the credit markets are yet to make an impact. Net lending to British businesses in July fell by its biggest amount since records began over a decade ago, the Bank of England said today, adding to fears that policymakers' efforts to free the credit markets are yet to make an impact.
In its latest trends in lending survey, the Bank said that the net flow of lending to businesses fell by £15.5bn in July after a £3.6bn drop the previous month. The Bank suggested the level of lending was likely to deteriorate even further. "Major UK lenders indicated that their stock of lending to businesses fell further in August," it said, adding that the weakness in July was across all sectors of the economy. Compared to the same month a year ago, lending to companies was down 3.3% in July and the Bank said the outstanding stock of loans to businesses by UK resident foreign lenders had contracted very sharply in recent months. "That is consistent with reports from market contacts of an increased bias towards domestic lending among banks internationally," the Bank said.
Mortgage approvals rose to 57,000 in August, from 53,000 in July, the Bank said. This is the seventh monthly increase in a row and the highest level this year. But the Council of Mortgage Lenders (CML) said gross mortgage lending in the UK plunged 37% in the year to August to £12.6bn. The figure represented a decline of 13% from July's revised total of £14.5bn. Meanwhile, the Bank's wider figures showed M4, the broadest measure of money supply, grew just 0.1% after a 1.3% rise in July. On the year, M4 was 12.6% higher - the weakest annual rate since September 2008.
Colin Ellis, an economist at Daiwa Securities SMBC, said: "Governor King said this week there had been some encouraging signs in July's broad money data. Yet M4 rose just 0.1% month on month in August, which meant that the year-on-year growth rate fell back to 12.6%. It is unwise to take too much from today's headline numbers without the sectoral breakdown, due on 29 September - but, on the face of it, they suggest quantitative easing is still only having a limited impact, which is not especially encouraging."
Britain borrows record 16 billion pounds in August
The recession's toll on Britain's public finances was highlighted Friday by official figures showing the government borrowed another 16.1 billion pounds ($26.3 billion) during August -- a record for the month. The rise took net borrowing to 65.3 billion pounds for the first five months of the financial year so far, the Office for National Statistics said -- more than double the 26.1 billion pounds seen at the same stage last year. Though August's borrowing was slightly lower than the 18 billion pounds forecast by most economists, it still represented the highest ever for the month, and the third biggest monthly borrowing total since records began.
Like most countries around the world, Britain's public finances have deteriorated sharply as tax revenues have sunk during the recession and government spending on such things as unemployment benefits has soared. At the end of August, Britain's net debt stood at 804.8 billion pounds ($1.315 trillion), or about 57.5 percent of the value of the country's total output. Many economists fear that the country's debt burden may actually exceed gross domestic product in the next couple of years amid mounting debt interest payments and rising unemployment costs.
Treasury chief Alistair Darling said in his April budget that the figure would likely peak just below 80 percent of GDP in 2013-2014, but his forecasts will likely be revised soon, especially as the recession in 2009 has been deeper than he expected.
Jonathan Loynes, chief European economist at Capital Economics, said borrowing this financial year looks like it will overshoot Darling's 175 billion pound forecast by around 50 billion pounds.
"With the main political parties now openly discussing plans to cut public spending more sharply than current plans allow, a severe fiscal squeeze is on the way," he said. With a general election having to be held by June next year, the political debate has moved swiftly on how debt will be brought down. Earlier this week, Prime Minister Gordon Brown admitted for the first time that his Labour Party government would have to make cuts in public spending.
A Treasury spokesman said Friday that Darling is meeting with fellow ministers in the run-up to the next set of budget predictions, due later in the autumn. However, he played down reports that a special set of discussions to identify potential targets for cuts had already been started in the wake of Brown's speech earlier this week. "In a week dominated by speculation on how soon and how much politicians will cut public spending, today's figures reconfirm the pressing need for strong measures," said Richard Snook, senior economist at the Centre for Economic and Business Research.
Britain's public debt hits £800 billion - the highest on record
Britain is clocking up debt at a rate of £6,017 per second as the Government struggles to balance the books. With tax receipts plummeting because of the recession, state borrowing grew by £16.1 billion last month — almost twice the entire budget for the 2012 Olympics. Net borrowing for the first five months of the financial year stood at £65.3 billion, compared with £26.1 billion at the same stage last year. Total borrowing soared past the £800 billion mark for the first time and total state debt as a proportion of national output reached 57.5 per cent.
Just to pay the interest on its ballooning debts the Government must find more than £30 billion a year — about £500 for every man, woman and child in the country. The figures from the Office for National Statistics (ONS) show that tax receipts in August dived by 9 per cent compared with August 2008, while public spending rose by almost 3 per cent. The widening gulf was bridged by borrowing. Spending on benefits grew by £900 million to £13.5 billion as unemployment soared.
Taking fright at the figures, foreign exchange dealers sent sterling diving to a four-month low against the euro. The value of the pound fell by more than 1 per cent against the dollar. Analysts said that the Budget forecast by Alistair Darling, the Chancellor, that additional borrowings would be £175 billion this year was not pessimistic enough and predicted that borrowing would be between £15 billion and £50 billion above that forecast. John Hawksworth, chief economist at PricewaterhouseCoopers, said: “It seems likely that budget deficits will overshoot Treasury forecasts not only in 2009-10 but for years to come.”
Philip Hammond, the Shadow Chief Secretary to the Treasury, said: “We used to worry about borrowing £16 billion in an entire year. Now Labour have done it in just one month. These shocking figures show the depth of Gordon Brown’s debt crisis and just how irresponsible he was to pretend that spending cuts weren’t necessary.” Mr Brown has been accused of misleading the Commons by berating the Conservatives for preparing public spending cuts when leaked Treasury documents show that he was examining his own cuts. This week he acknowledged for the first time that cuts in public spending would be necessary and yesterday he began holding a series of meetings with Cabinet ministers to discuss cuts.
Around the world, governments have kept spending to prevent a global depression, sending state borrowing soaring to $35 trillion, according to the Economist Intelligence Unit. The G20 leaders will discuss when to reverse stimulus policies of high public spending and ultra-low interest rates when they meet in Pittsburgh next week. Measured as a proportion of national income, total UK government borrowing is not out of line with other rich nations, but it is growing much faster. The ONS figures exclude many public sector liabilities, including unfunded pension promises and some costs of the banking bailouts.
Gemma Tetlow, of the Institute for Fiscal Studies, said that the Treasury’s coffers would be boosted by the rises in fuel duty and stamp duty and the reinstatement of 17.5 per cent VAT. A Treasury spokesman said that the figures were in line with government forecasts. “They reflect the impact of the global financial crisis on tax receipts as well as the action we are taking to support the economy and invest to benefit from the recovery.”
Danish housing bubble "one of the worst in the world"
The burst of the Danish housing bubble will be costing an extra 25,000 jobless, a major national deficit and lower growth in coming years. The housing bubble, that coupled with the government’s rates freeze and repayment-free loans became inflated until 2007, has drastically worsened Denmark’s economic crisis and its burst has weakened Denmark’s ability to combat the crisis.
According to calculations carried out by Nordea for Politiken, some 25,000 more people will lose their jobs as a result of the bubble than if the Danish housing market had not been hit by one of the worst price bubbles in the world. Growth would be a third higher in the next few years and the public finance deficit would be DKK 37 billion in 2011 instead of DKK 60 billion. ”If we had avoided overheating, the crisis would have been less serious – perhaps two-thirds of what it is now,” says Nordea Chief Economist Helge Pedersen. ”And the government has generally had control of the factors that created the bubble,” he adds.
Several economists that Politiken has spoken to have confirmed how the housing bubble burst has drawn the rest of the economy down, pointing out that the problems of greater public deficits and lower growth make it more difficult to emerge from the crisis. ”A lot would have been different; we wouldn’t have been hit so hard by the crisis and we would have had more leeway to combat it,” says former Wise Man and Århus University Economics Professor Torben M. Andersen.
Worse evils exist than corruption
Did you know that a global poll of business executives found two in five have been asked to pay a bribe when dealing with business institutions? Half of these estimated that corruption raised project costs by at least 10 per cent. One in five of the executives claimed to have lost business because of bribes by a competitor. More than a third felt that corruption was getting worse. Moreover, politicians and officials in emerging economies are estimated to receive bribes of between $20bn and $40bn annually – equivalent to some 20-40 per cent of official aid.
No doubt reactions to these estimates will range from “Were you born yesterday?” to “There’s capitalism for you”. But although one can, as always, argue about the methodology, these estimates are unlikely to be an overstatement. They come from the latest global corruption report of Transparency International – a non-govermental organisation that, far from being a leftwing agitprop group, is supported by many high-ranking business people and sponsored by the accountancy firm Ernst & Young. Although there is much to query in some of its attitudes, it cannot be at the level of primitive disbelief.
But before getting into the higher theology, most readers will want to see how their own countries perform in the corruption or anti-corruption stakes. There is a corruption (or rather anti-corruption) perceptions index in which 180 countries are ranked “in terms of the degree to which business people and country analysts perceive corruption to exist among public officials and politicians”. The highest-scoring countries are those believed to be least corrupt. Not surprisingly, Denmark, New Zealand and Sweden tie for first place, scoring 9.3, closely followed by the authoritarian Singapore. Further down the list Austria, scoring 8.1, is slightly ahead of Germany on 7.9.
The UK and Ireland tie for 16th place, both scoring 7.7. The US is 18th with 7.3 and France, in 23rd place, ties with Chile and Uruguay. Few will be surprised to find Somalia, Burma, Iraq, Afghanistan and Congo among the bottom 10. There is a rough correlation between low income and corruption, but with notable exceptions. Bhutan, Botswana and Jordan are low-income countries perceived to be relatively uncorrupt.
Some might find more interesting the “Bribe Payers Index”, which ranks 22 of the “most economically influential countries” according to the perceived likelihood of their companies to bribe abroad. The index is sadly and predictably headed by Russia, with China, Mexico and India following a little way behind. The main 11 industrial countries selected by TI nearly tie with each other at the bottom, with Belgium – believe it or not – perceived as slightly less likely than the others to bribe abroad.
One puzzle is why the US does not receive a higher rating. A colleague who follows these matters describes US anti-corruption legislation as the “gold standard”; and, by and large, the TI analysis supports this verdict. The 1977 Foreign Corrupt Practices Act was “the first comprehensive prohibition by any country against bribing foreign governments for business purposes”. Enforcement has been much toughened in recent years. Some 46 high-ranking individuals have been charged criminally in the last decade, mostly within the last three years. Most of those convicted received “substantial prison sentences”.
It may be that in as large and complex an economy as the US, some bribes escape even the tightest of legal nets. It also takes time for the most recent increase in stringency to be reflected in international perceptions. Moreover, corruption indices have inevitably to be based on public perceptions; and a view of US business as “rough and tough” and even a dislike of the recent Bush administration may affect the rankings. Unhappily, there are no such puzzles in relation to the UK. The TI report confirms the popular impression of a high level of corruption in the construction industry. Since the Organisation for Economic Co-operation and Development Anti-Bribery Convention came into force in 1999, the US has brought 103 cases, Germany more than 40, France 19 and the UK just one, up to the end of 2008.
Inevitably, the suspension of the Serious Fraud Office’s investigation into suspected bribery by BAE Systems to secure a Saudi arms deal – after a personal intervention by Tony Blair – dominates the UK section. The subsequent appointment by BAE of an external committee, chaired by the former chief justice Lord Wolf, on ethical policies and processes is a good deal better than nothing. The same can be said of the establishment by 30 European defence industry associations of a set of anti-bribery standards. Yet I have a last reservation. Governmental sponsoring of arms sales to dubious regimes would be undesirable even if no bribes were involved. There is a danger that too much emphasis on their corrupt aspects may detract attention from the greater evil of the arm sales themselves.
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