Water supply: Open settling basin from the irrigation ditch in a California squatter camp near Calipatria
Ilargi: In the face of the emptiness exhibited by all parties in Copenhagen this week, here's a dose of reality from Stoneleigh. Renewable energy, sustainability and green shoots in North America? Just talking about it doesn't fly. And the decisions that should have been made to accommodate these initiatives, were not. Not when they were needed. It's too late now. So you can safely ignore anything Obama says in Denmark. It's not going to happen. We've heard for 20 years that it was our last chance. We hear it again today. But the last chance is now long gone. We can't prevent the damage we've done anymore. All we can do is to prepare as best we can to live with the consequences.
Stoneleigh: Today we turn to the topic of our energy future, using my own province of Ontario as an example of what is being attempted in North America, but too little and too late. As renewable energy proponents in Ontario celebrate a Green Energy and Green Economy Act that introduces European-style feed-in tariffs, and talk of this province being entirely powered by renewable energy, I wanted to inject a dose of reality.
Some 85% of Ontario's existing generation capacity will reach the end of its design life within 15 years. While demand has fallen since 2007, and supply has increased with the refurbishment of reactors, creating more of a supply cushion, the easing of the situation leads to a false sense of security. The time horizon for replacing conventional generation is such that a supply crunch looms down the line, even though the coming depression will in some ways buy us some time due to demand destruction.
As with other forms of energy supply, demand collapse for electricity sows the seeds of supply collapse due to lack of timely investment in both supply and maintenance of existing infrastructure.
Feed-in tariffs for renewable power were initiated in Europe, at least partly in order to reduce dependence on Russian energy supplies as much as possible. Eastern Europe knows only too well the strings attached with that kind of dependency, and Western Europe will find out in the coming years. Russia will enjoy yanking Europe's chain, but at least Europe has developed a proportion of its renewable energy potential, which will blunt the effects to some extent. North America was not so foresighted.
A feed-in tariff is a premium price paid for renewable electricity over the long term (typically a 20 year contract) in order to facilitate project financing and stimulate investment. It varies with technology and project size, reflecting the different cost structures of different forms and sizes of generation, in order to provide each with a similar rate of return. It may also vary with resource intensity - paying a higher rate where resource intensity is lower in order to encourage distributed generation and maximize domestic renewable potential.
The approach is to fix a price and allow the market to decide the quantity it is prepared to provide at that price. In addition, much of the cost of connection was covered by the rate base (a system called shallow entry), making investments in renewable power much more attractive. Over the last decade, countries like Germany, Spain, Denmark and the Netherlands have made impressive strides in developing renewable power as a result. They have also built the renewable energy companies that now supply later movers elsewhere.
This is highly counter-intuitive to the comparative advantage mindset which dominates in Northern America, where the cheapest option has been encouraged, no matter what unfortunate long-distance dependencies are created in the process. Until relatively recently renewable generation was contracted for through an RFP process, where a small amount of generation was specified and the lowest bids to provide it accepted. This under-estimated renewable potential, providing a ceiling rather than a floor.
It favoured large projects that could benefit from economies of scale rather than distributed generation. It continued the central station model of generation (large plants at long distances from load) rather than achieving the reduced need for power transmission advantage of embedded generation.
It also favoured only the cheapest technology (big wind) rather than developing a range of options. (Wind has a reasonable EROEI, but it is intermittent and also has a particularly poor match to a load profile that has its peaks on hot, humid and still days in the middle of summer.) Forcing projects to bid in very low meant that many would have been only be marginally viable and were often not built at all.
For something as essential as electricity, this was risky, especially considering that there was also chronic under-investment in the grid infrastructure needed to carry power over long distances. The regions with the most under-developed infrastructure were often the ones with the most renewable energy potential. These were also often distant from load. In addition, the cost of connection fell entirely on the generator, no matter how far downstream the necessary modifications may be or how disproportionate the cost may have been to the size of the project (a system called deep entry). This made many potential projects completely uneconomic.
The successor to the RFP system in Ontario was the Renewable Energy Standard Offer Program (RESOP), which offered one standard price for all generation (11 cents/kWh and 3.5 cents/kWh for non-intermittent power during peak periods) except solar PV (42 cents/kWh). I critiqued the program at TOD:Canada in October 2006; see Standard Offer Contracts - the Future for Renewable Generation?
Once again, the comparative advantage mindset was evident, as only the cheapest renewable generation would be able to compete at a standard price. The program was pitched to homeowners in the full knowledge that, at the rate offered, very small systems would be money losers for their builders. In May 2008, RESOP was suspended, leaving renewable energy companies and potential projects in limbo for 18 months until the launch of the new Feed-In Tariff (FIT) program. All of this was wasting valuable time in which renewable generation might have been developed.
FIT goes much further in the direction of the European legislation it is intended to mimic, but still has many flaws in terms of tariffs, tariff bands, financial assumptions and a broad appreciation of the public interest (properly valuing environmental attributes for instance). There is not enough tariff band differentiation at the smaller end of the scale, and tariffs are often too low for smaller-scale projects to be viable.
Technologies that must create their own renewable fuel, such as anaerobic digestion, have been particularly undervalued considering the benefits they provide in addition to renewable power. The chances of some of the most beneficial technologies being developed under these conditions, in the remaining time before financing becomes impossible, are very low.
There is to be a review in two years, but that review, if it goes ahead at all, will be happening in the middle of a depression. Demand will be depressed, power prices will be very low, private financing will be all but impossible, and it will be politically very difficult to justify special treatment for more expensive power, even though that power will be needed in the long run. In fact, I would be surprised if the contracts now being offered would indeed be honoured for 20 years. Twenty years is an eternity in times of great upheaval, and governments in other jurisdictions have been known to unilaterally rewrite inconvenient contracts in the power sector.
The Ontario grid can only accommodate perhaps 2500MW of renewable generation, which is a small fraction of the projects currently being contemplated by eager proponents. In fact the available capacity has consistently decreased as Hydro One has discovered additional problems with voltage stability on long feeders and reverse flow through some of its transformers.
The Ontario Power Authority expects all the available capacity to be fully subscribed during the first month of the FIT program. Anything coming later would have to wait for additional grid capacity to be developed, and that will not happen in a depression in a province which is already in a financially precarious position before the credit crunch begins to bite here.
There are grand plans for the development of twenty new transmission lines in ten years, which would be ridiculous even in good times, given that it has taken six years for the single Bruce to Milton line just to reach the environmental assessment stage. (And that was under conditions of time pressure, due to a take-or-pay contract with a private company refurbishing a nuclear reactor, for which the government of Ontario will be on the hook for a billion dollars when it fails to build the transmission line in time.)
The distribution investment that would also be necessary hasn't even been planned yet by the over 80 local distribution companies which would be responsible for it. A vast amount of grid investment would be required for the grid even to be able to continue carrying the power it does now, and ambitious expansion plans are pure pie-in-the-sky.
North America could not have copied European achievements in renewable power entirely, even if it had chosen to invest in a timely fashion. The larger geographic area, lower population density, lower feeder loads and under-developed rural grids would have held back development in any case, but much more could still have been achieved than will now be possible in the very limited time still available. North America will thus be left with a much greater legacy of structural dependency on aging conventional infrastructure.
When Peter Cummings and his corporate lending team at HBOS of the UK welcomed leading property entrepreneurs to their hilltop bash at Le Mas Candille hotel during the industry's Cannes jamboree in March 2007, it was difficult to believe that the real estate dream would become a nightmare for the attendees in just a matter of months. Such lavish dinners were just one of the many signs of excess during the heady years of the property boom. Certainly, when the crash came that summer, HBOS found itself among many overexposed to a market undergoing its sharpest fall on record.
Commercial property values fell by more than 40 per cent in markets such as the UK, the US, Spain and Ireland, posing problems for boomtime investments made largely with debt. After a time lag that partly reflects government support, the contagion from these losses is only just beginning to be felt in the global banking system. Further restructurings, defaults and forced sales are inevitable as breaches of loan agreements increase and debt matures - of which the current problems in Dubai, facing a refinancing of $3.5bn (€2.3bn, £2.1bn) of bonds owed by a property group linked to the state, is just the biggest example to date. As with the Gulf emirate's property debt, there are fears of how widely defaults will be felt within the banking system.
"Real estate debt for banks is the pig in the python and the question is when it will be digested," says Patrick Vaughan, a well-known European property investor. "It has looked like it would kill the python." The scale of lending across the world - with an estimated £3,000bn ($4,940bn, €3,300bn) of property debt outstanding in the US and Europe - and the ferocity of the crash has meant institutions have not been able to afford action such as in the early 1990s, when panicked banks dumped distressed property in spite of more moderate market declines.
HSBC estimates that 85 per cent of UK loans made in the past five years are in breach of lending agreements. But banks are ignoring such problems. Instead they are rolling over loans as these near maturity, in the hope that capital values and loan-to-value (LTV) ratios will rise once again to refinanceable levels. Analysts fear banks are storing up losses, particularly for lesser quality property. CB Richard Ellis, a consultancy, estimates that there are about £80bn ($132bn, €88bn) of poor quality property loans in the UK alone, or 27 per cent of all the British sector's debt.
More than £30bn worth are in breach of debt agreements or in default , according to De Montfort University - a tally that has doubled in just six months. "Let me not pretend that it is not something that we are looking at closely. It represents a risk. We recognise that loans with LTVs of over 100 per cent will not be refinanced," says Andrew Haldane, director for financial stability at the Bank of England. "The hope would be that new sources of finance will come to the market before the refinancing dates." The problem becomes acute as borrowers face repayment calls on loans in negative equity that they cannot meet and the financial market cannot afford to replace. Dubai is just the start of refinancing problems.
Much of the debt was generated during the boom of 2001-07, when deal volumes grew on average every year by 38 per cent in the US and 24 per cent in Europe - fuelled by cheap debt that in the case of the US is estimated to have accounted for more than 90 per cent of the $1,400bn transacted. Such sums illustrate the voracious appetite of the real estate sector but also the over-eager lending practices among banks desperate to be involved in the booming property market.
Swept up in the parties, the meals in the south of France and the larger-than-life property tycoons with super-yachts, it was easy for bankers to become overwhelmed. Everyone was making money, simply because there was always another buyer with another bank willing to take the price even further away from the twin fundamentals of property value - rental income and replacement cost. So keen were the banks to give money to the sector that many started to give speculators cash as well as debt, sometimes on structured terms that guaranteed an upside for investors with only the thinnest of "skins" in the game - 5-10 per cent of their own equity perhaps. The "meat" of the money, and the risk, was with the banks. This came to an abrupt end in 2007; finance to the sector was turned off.
In the UK, the lending market was dominated by HBOS and Royal Bank of Scotland, accounting for almost half of the £225bn of net outstanding debt. Naturally, concerns have rested with them as values have fallen. Lloyds Banking Group, the new owner of HBOS, is still taking writedowns on its commercial property book, the legacy of the empire built up by Mr Cummings. Impairment charges of £22.1bn since the end of last year were related substantially to HBOS's real estate spree. RBS was just as keen to offer structured finance, creating a loan book that Stephen Hester, chief executive, is now dealing with in robust fashion. RBS will put £39bn of property loans into the government's asset protection scheme: loans that are either being managed by its workout teams or on a high-risk list.
The APS will prove crucial to keeping such loans afloat. According to Alan Carter of Evolution Securities, government economic stimulus measures have provided "considerable assistance" to the sector. "To be clear, in absolute terms we regard the ongoing indebtedness of the real estate sector as a material risk. However, it is evident that the total meltdown in asset valuations has been avoided, at least for now," he says. Elsewhere, Ireland has created the National Asset Management Agency, which will buy €77bn ($114bn, £69bn) of toxic property loans. The Irish banks were particularly carefree in lending to some of the more risky types of real estate, such as development land. The US government has meanwhile acted to underwrite securitised real estate debt and relaxed the rules on defaults.
Ian Marcus, chairman of European real estate investment banking at Credit Suisse, says: "Real estate is not high on the agenda for government but banks certainly are." Such efforts have helped secure the sector from the mass foreclosure of commercial developments but there are still worries about what happens as more property becomes empty amid the recession, which impacts on the rental income used to service debt. Income will be key for banks, which ultimately are sanguine as long as interest is paid every month. Nick Robinson, the former managing director of corporate real estate for Lloyds, told the FT in September that further losses would be from borrowers having lost income from the failure of their tenants' businesses.
For his part, Mr Marcus says: "Banks may overlook a breach of loan-to-values but they will take action if the interest is not paid. Loans then become impaired and banks will have to account for [them] in a different manner. A serious impact from a tenant default means that any borrower will have significant difficulties in refinancing their debt." The scale of refinancing represents one of the biggest hurdles for property investors and their banks to overcome. About $1,600bn of commercial mortgage debt is estimated to mature in the next five years in the US and a further €366bn in Europe. This represents a massive equity call on the property sector.
In July, a delegation of property financiers used a forum with the Bank of England and Treasury to warn of the threat posed by the lack of finance to cover loans due for renewal. Those in the group estimate that £100bn could be needed to recapitalise the UK property sector, taking it to a sustainable LTV ratio, which means the industry could be in negative equity until 2017. "We've got very excited about the £7bn raised in the UK listed sector but this shows that there is several multiples of that needed to bring loans to safety," says one group member.
Refinancing has not been more of a problem before because banks have been able to roll loans over, even when in breach. In fact, banks can make good money in bad times by boosting margins and fees. Various phrases have been coined to describe the trend - "a rolling loan gathers no loss" quickly became a cliché - but bankers warn that such manoeuvres are not a long-term solution when the need is to reduce exposure to the sector. One banker says that institutions are kicking the can down the road pretty far but "this is ultimately just delaying the problem in the hope that the world will be a better place".
Asustained property recovery would go part of the way to saving the situation, although the rebound is still uncertain. UK commercial property has seen 3.2 per cent price growth since the summer, for example, but that has been based on demand for prime property. So-called secondary property - the majority of the market - is still a problem. "Banks are going to struggle in particular to refinance secondary property where values have fallen steeply until the market recovers," says Max Sinclair, who co-heads the UK division of Germany's Eurohypo.
The chief executive of one leading property company says: "The banks are terrified, as they cannot afford the provisions. They simply can't sell me something at 60 per cent [of] book value as they can't deal with the losses, and I won't buy it for a penny more." There will be solutions, with banks exploring exit routes ranging from joint ventures to establishing funds and real estate investment trusts. Developers are taking on their sites. It will help that lending is again very profitable, given the high margins and fees on property generally being sold below long-term value. The other banking adage - that good loans are made in bad times - will be true for those who still have the appetite.
Indigestion at some of the larger banks could continue for many years to come, however. Nick Leslau, chief executive of Max Property and a veteran investor, says: "I was buying distressed property from the 1990s crash a decade later. This time is worse. It will be a long process." It could certainly be for the many former clients of HBOS, given difficult years ahead under the gaze of the bank's 200-strong restructuring team. Mr Cummings departed in January and relationship banking has become workout planning. The parties in the south of France are a distant memory.
Default to disposal: Simon Halabi has become one of the most prominent casualties of the crash to date, having seen a portfolio once valued at £1.8bn ($3bn, €2bn) fall into default and now head swiftly for disposal. Through offshore family trusts, Mr Halabi's Buckingham Securities amassed a nine-building London portfolio including the Aviva Tower and JPMorgan's offices on Victoria Embankment. A £1.15bn loan securitised by Société Générale at the peak of the market was declared in breach and then in default after the portfolio value dropped to £929m.
Ilargi: John Mauldin says the US will never get to a $2 trillion deficit, since the markets won’t finance it. The US won’t hyperinflate either, and gold won’t go to $15,000. The bond market won’t let it happen. Sound familiar?
Here's Why Our Massive Debt Mountain Will Kill Us In The End
- We're borrowing ourselves to death
- But government spending doesn't fix anything--investments must be made in the private sector in order to create jobs
- The U.S. will not reach a $2 trillion deficit--because government will raise taxes and cut spending before that happens. These moves will kill the economy.
- Another financial crisis will occur if there is no credible plan to get back to manageable debts
Citigroup in race to repay bail-out funds
Citigroup is racing against the clock to convince US authorities that it be allowed to repay $20bn of bail-out funds, with insiders and regulators arguing that unless the bank acts in the next 10 days it will have to wait for more than a month. The short window for a decision on the repayment of funds from the troubled asset relief programme raises the stakes for Citi in its quest to free itself from the shackles of the government, which also owns a 34 per cent stake in the lender.
Separately, the Kuwait Investment Authority, the Gulf state’s sovereign wealth fund, has made a $1.1bn profit after selling its entire 5 per cent stake in Citi for $4.1bn – less than two years after acquiring preferred shares in the ailing bank during the financial crisis. The sale earned the sovereign wealth fund a 37 per cent return on its investment. Citi’s need to pay back the Tarp funds has been heightened by last week’s surprise announcement that Bank of America had raised $19.3bn to repay $45bn. That move left Citi and Wells Fargo as the only two big banks that have yet to repay Tarp and remain subject to the strict limits on compensation and operations that accompanied last year’s government cash injections.
People close to the situation said that unless Citi could launch the capital-raising effort required to pay back Tarp by the middle of next week, it would become practically impossible to do so until after it reports year-end results in mid-January. Lawyers said it was not technically impossible to raise capital between the end of a quarter and the announcement of results but added that disclosure rules could make it difficult, especially for a company as complex and geographically diverse as Citi.
Citi’s executives have been lobbying Washington to be allowed to repay Tarp, arguing that the bank has cash reserves of more than $240bn and its financial performance is improving. However, Citi’s situation is further complicated by the US government stake. People close to the situation said the government was willing to co-ordinate a sale of at least part of its stake with Citi’s own capital-raising but the tight timing – and the authorities’ lingering concerns over the bank’s health – might delay that.
Citi declined to comment but insiders acknowledged that unless it could launch a share offering by December 14 or 15, it would probably have to wait until at least late January. BofA’s ability to raise $19.3bn – more than its $18.8bn target – in one day at a slight discount to the previous closing price underlined investors’ confidence in the ability of banks to rebound, especially when free from government restrictions.
Kuwait Investment Authority Sells $4.1 Billion Citi Stake
The Kuwait Investment Authority, the Gulf country's sovereign wealth fund, said Sunday it sold a $4.1 billion stake in Citigroup Inc. making a profit on the deal. The fund, also known as the KIA, said it made a $1.1 billion profit from the sale, or a 36.7% return on its investment, according to an emailed statement. "The authority converted its preferred shares to common shares following negotiations with the bank's administration, selling all of the shares for $4.1 billion," the statement said.
The KIA invested $3 billion in Citi and another $2 billion in Merrill Lynch & Co. in 2008 as Wall Street lenders turned to outside investors to replenish capital hit by subprime-mortgage losses in the U.S. Sovereign wealth funds are unwinding their investments in Western banks after buying big chunks of lenders when share prices hit rock bottom at the height of the global financial crisis. "At the end of the day, sovereign wealth funds are just institutional investors that look to make returns for their shareholders and the KIA found an opportunity to do just that," Hani Kablawi, a co-chair of the sovereign advisory board at Bank of New York Mellon Corp., said in a phone interview.
Kuwait's exit from Citi comes as rival Gulf sovereign wealth fund, the Abu Dhabi Investment Authority, may have to overpay on about $7.5 billion worth of the Citi's shares it's committed to buy at $31.83 a piece in a deal struck two years ago. The United Arab Emirates-based investment fund, also known as ADIA, committed in November 2007 to pump billions into Citi in return for an 11% dividend up to March next year when it has to start buying the bank's common stock. The bank's stock traded in New York closed at $4.09 last week.
Both the KIA and ADIA helped rescue Citi, which turned to the U.S. Treasury twice for infusions of capital, which ultimately left the U.S. government owning 34% of the bank. For a time in March, its stock traded below $1 a share. The Government of Singapore Investment Corp. said in September it made a $1.6 billion profit by selling about half its stake in Citi since converting its holdings from preferred shares to ordinary shares earlier in the month. Saudi Arabia's Prince Alwaleed bin Talal remains one of Citi's largest individual investors since he helped rescue the bank from near collapse in the 1990s.
Gulf sovereign wealth funds, flush with petrodollars from a six-year oil rally that ended in 2008, poured billions of dollars into Western lenders last year as they ran in trouble. The Qatar Investment Authority, the sovereign wealth fund of the world's largest liquefied natural gas exporter, sold in October a £1.4 billion ($2.3 billion) stake in British bank Barclays PLC, making a profit of about 610 million pounds.
The Qatari authority, which continues to hold about 7% of Barclays' shares, is the second sovereign wealth fund to exit the British bank after Abu Dhabi made about 1.5 billion pounds when it sold the bulk of its Barclays stake in June. The KIA is one of the oldest and most experienced of a handful of Middle East government investment funds, with assets estimated at more than $200 billion. Its investment in Citi had drawn criticism from Kuwaiti lawmakers fearing big losses for the nation's overseas wealth.
Big Paydays for Rescuers in the Crisis
The white knights that came to the rescue of banks during the financial crisis are going home, with their pockets full of bounty from their good deeds. In less than two years, many of the biggest overseas government investment funds, known as sovereign wealth funds, have reaped huge gains from bailing out financial institutions, and in turn, the global financial system.
In the latest announcement, Kuwait’s sovereign wealth fund said on Sunday that it had booked a $1.1 billion profit on the stake it took in Citigroup in January 2008. That equals a 37 percent annualized return on its initial $3 billion investment. Other sovereign wealth funds — including those backed by the governments of Singapore, Qatar and Abu Dhabi — have also recently cashed out stakes in foreign banks for comparably large gains.
The hefty returns highlight how some savvy government funds have been able to profit from the financial crisis, even as most ordinary investors have been pummeled by billions of dollars of losses. It also calls into question whether such funds will act as long-term investors, as many initially suggested, or merely short-term profiteers. Many sovereign funds invested in the early days of the crisis as banks scrambled to find investors willing to plow in money and exacted lucrative terms. (Swings through Asia and the Middle East were so common that bankers coined the phrase "Shanghai, Mumbai, Dubai, Goodbye" to describe their fund-raising tours.)
But as financial stocks continued to plummet last year, the so-called smart money supplied by foreign governments no longer looked so sure. Now, as bank shares have rebounded faster than most analysts had projected and governments face internal political pressure at home, the funds are racing to lock in gains. "They didn’t panic into selling at the bottom of the market," said Mohamed El-Erian, chief of Pimco. "And now they can sell." GIC, an investment arm of Singapore’s government, said in September that it turned a $1.6 billion profit by selling about half of its stake in Citigroup.
In June, the International Petroleum Investment Company, which is wholly owned by the Abu Dhabi government, said it would sell a big part of its investment in the British bank Barclays, making a profit of roughly £2 billion on a £2 billion investment. In October, the Qatar sovereign wealth fund said it was selling a part of its stake in Barclays, also at a healthy profit. Mr. El-Erian said data was limited on the specifics of how the big sovereign wealth funds have fared through the crisis. Norway, one of the few such funds that provides regular data and has invested in financial firms through its general financial investments, has reported that it is having a strong year.
The great unraveling by foreign governments may put additional pressure on the United States government to begin exiting its bank investments, too. Bank of America said last week that it expected permission from regulators to soon repay the $45 billion in taxpayer money it received. Citigroup, in which the government holds $20 billion of preferred shares and nearly a 34 percent ownership stake, has made paying back the government a priority but has not reached a deal with the Treasury Department for repayment.
Of course, not every bank investment has been a winner. The China Investment Corporation saw its $3 billion investment in the Blackstone Group turn south, especially after the firm’s initial public offering did not perform well. Temasek Holdings, another sovereign wealth fund backed by the government of Singapore, replaced its leadership team and overhauled its investment strategy after big bets on Barclays and Merrill Lynch did not pan out. The Abu Dhabi Investment Authority has had a similar experience with its early investment in Citigroup.
Still, the decision by the Kuwait Investment Authority to sell its stake in Citigroup came as somewhat of a surprise. It invested about $3 billion in Citigroup in January 2008 alongside other prominent investors, including Adia, the GIC, the New Jersey Division of Investment, and Citigroup’s founder, Sanford I. Weill. Around the same time, the authority put $2 billion into Merrill Lynch, the troubled brokerage house taken over by Bank of America last year.
In September, the Kuwait Investment Authority said that it had no immediate plans to sell its investments in Citigroup or Bank of America because its financial strategy was based "on a long-term vision." The government investment fund had agreed to convert its preferred shares of Citigroup into common stock. But on Sunday, it announced that it had sold that stake for about $4.1 billion, producing the $1.1 billion gain. Citigroup’s ordinary shareholders, however, have not fared as well during the last two years. The company’s stock was trading above $25 a share in January 2008 when Kuwait took its stake; it is now trading at about $4 a share.
Ilargi: Criticism of recent unemployment numbers continues unabated. It’s starting to be entertaining. There's a lot of disbelief out there. Dave Rosenberg notices the same I did: the ISM reported a contracting services sector mere days before the BLS saw it expand.
Was The Drop In The U.S. Unemployment Rate A Big Deal?
by David Rosenberg
In our opinion, the answer is no. This was the eighth time we have seen the unemployment rate go down in a month since it bottomed back in October 2006. Nothing moves in a straight line. The peak still lies ahead of us. In the prior cycle, the unemployment rate bottomed on April 2000, at 3.8% and peaked at 6.3% on June 2003. During that time, we saw the jobless rate fall five times. In the early 1990s cycle, the unemployment rate actually fell no fewer than six times.
Declaring victory because of a one-month wiggle can be dangerous. Especially since a key reason why the jobless rate dipped was because the ranks of discouraged workers who exited the labour force due to grim job prospects jumped 60,000 to 357,000 last month. As for the -11k print on Friday’s headline payroll report, unadjusted, the number was +80k, which therefore goes down as the third softest November reading in the past 18 years. November is normally a month where between 300k and 500k workers find a job before the seasonal adjustment kicks in. Something to keep in mind.
It’s remarkable nobody talks about this. The big surprise in the payroll data was the service sector component; it rose 58k. But we know from the ADP report that service sector employment fell 81k, which was fractionally worse than the 79k decline in October. Such a discrepancy has occurred less than 3% of the time in the past, and each time, the following month after the big gap, there was a convergence ... with headline nonfarm payrolls swinging 100k lower on average, which would imply a 111k decline when December’s figure comes out.
Also take note that the +58k print in the service sector payroll was completely at odds with the 41.6 reading in the ISM non-manufacturing employment index in November — a figure that in the past was consistent with a -192k tally in service sector payrolls and never before aligned with a positive number. Go back to the 2001 recession, and the worst ISM non-manufacturing jobs subindex was 43.9 (right after 9/11) and here we published a figure that was more than two points shy of that!
So as we wonder how the headline number could only be -11k on Friday, there were some very lumpy increases in some very non-cyclical segments of the economy:
• Administration/waste management +87k
• Health/education +40k
• Government +7k
The rest of the economy shed 145 jobs and the declines were spread across nearly 60% of the industrial base from retail, to transports, to manufacturing, to construction. For some reason, we didn’t see this dichotomy mentioned anywhere in the weekend press. The Canadian employment data, while robust on the surface, also had its own peculiarities — like half the gain being in education (more teachers in November?); wages declining (even with a lower unemployment rate?); and the workweek contracting (more bodies, fewer hours — reverse of what we saw stateside). We would have to think that Mr. Carney is going to look through this spurious piece of Household employment this week, especially since GDP growth is already coming in well below official forecasts.
There is a case to be made that we will go through a continuation of the good news on the job front, and the question is going to be how the equity market deals with the new normal of no more job destruction and no more cost containment. Pricing power better come back along with what could be a temporary — underline temporary — jobs spurt due to:
• A skew from the seasonal adjustment factors caused by the massive losses from November 2008 to May 2009.
• Obama hiring 1.5 million people during Q1 to conduct the census (it will last into April).
We are about to see the President (tomorrow, in fact) announce a slate of job creation measures including tax credits for new hiring and additional infrastructure spending as well as more financial aid to state and local governments. Based on what the automakers are saying, we should be seeing a 10% sequential rise in motor vehicle production in the first quarter as well. The November employment report showed there to be upward revisions, a hefty gain in temp agency employment and a healthy increase in the workweek — all leading indicators and the first time we have seen such a trio in three years.
That said, we think that once we get beyond the census effect post first-quarter, employment is likely to weaken again and we continue to see new highs ahead for the jobless rate. Economists who continue to use the experiences of the post-WWII recession, which was a mere correction in GDP in what was a secular credit expansion, are doomed to failure, as so many were heading into the collapse of late-2007, 2008 and early 2009.
Those unbelievable US payrolls
Just how amazing were the US payroll numbers released on Friday?
So amazing they’re verging on the (perish the thought) unbelievable, according to some analysts.
The consensus forecast among analysts for the November job loss had been -130,000, with even the relatively optimistic and sometime-clairvoyant economists at Goldman Sachs forecasting -100,000. The official data showed a fall of just 11,000 — about 90 per cent fewer than the consensus estimate.
Thus, perhaps, ING’s Rob Carnell pouring some cold water on the numbers on Monday:In our view, the only potential fly in the ointment of this labour report is how believable it is. Payrolls has been making very, very slow progress in recent months, and such a dramatic turnaround will raise eyebrows, and may not be taken at face value by many. An improvement in the payrolls series always looked on the cards from last month. But most of the labour market data in the run up to this release had been consistent only with a very small step forward, so we may need to see this backed up again next month before concern about the labour market can really be filed away as ‘last year’s worries’.
Further support for the turnaround in the employment sector came from hours worked - which gained 0.2 hours on the month, helping to push weekly earnings higher. Hourly earnings continued to decline and now stand at only 2.2% YoY. But they lag employment growth by up to two years, so it would be a bit early to expect much improvement here.
In contrast to the weak November non-manufacturing ISM survey’s employment index yesterday, which registered only a small increase from very low levels, the service sector apparently generated 58K jobs in November. Strong gains in temporary help jobs (usually a retail sector phenomenon) were a big factor here, so anecdotal reports of relatively soft retail sales in November may see some of these jobs rapidly removed after the end of the year, once sales have finished (if demand does not improve)
We are also slightly curious about the apparent surge in government jobs, which on revision have risen by more than 50K in the last two months. When state and local finances are in such a deep mess, even the Obama fiscal package is unlikely to have generated this rapid turnaround in the public sector. More believably, goods producing, construction and manufacturing jobs all saw continued large falls.
When the Performance Looks a Little Too Good
Sanmina-SCI, the supplier of electronics services, is loaded with debt and in each of the last eightyears has lost money. Its shares have risen more than 600 percent since the stock market rally began on March 9. Wal-Mart Stores, the discount retailer, has lots of cash on its balance sheet, has very little debt and has consistently turned a profit. Since March 9, its shares have gained just 14 percent.
The disparate treatment meted out to these two companies by the stock market highlights an unusual and, in some ways, worrisome phenomenon: to an extent not seen in decades, shares of companies with weak balance sheets have been soaring, generally outperforming firms with stronger fundamentals. In part, this is a consequence of the terrible pummeling given to riskier assets of all kinds during the worst months of the financial crisis. Shares of companies that were deemed to be weakest were hit the hardest. It’s only natural that they would bounce back the most at the first hint that financial disaster had been averted.
But the performance gap between the weak and the strong has rarely been as pronounced as it has been since March’s market lows. The extreme outperformance of the more speculative stocks could make them vulnerable to another market shock. Ford Equity Research, an independent research firm based in San Diego, rates stocks’ financial quality based on a number of factors, including a company’s size, debt level, earnings history and industry stability. All told, Ford Equity follows more than 4,000 stocks. Those in the bottom fifth of its ratings — including Sanmina-SCI — produced an average stock market return of 152 percent from the beginning of March to the end of November, according to an analysis conducted for The New York Times.
The stocks in the highest quintile for quality — including Wal-Mart — produced an average gain of 66 percent over the same period, or roughly 85 percentage points less. That is the biggest disparity over the first nine months of any bull market since 1970, which is the first year for which Ford Equity has quality ratings. Historical comparisons to bull markets prior to 1970 must rely on a proxy for financial quality, and perhaps the best available is market capitalization. Not all large-cap companies are financially healthy, of course, and not all small caps are weak. But, historically, as a group, the difference between the large- and small-cap sectors has proved to be roughly correlated with the disparity between high- and low-quality stocks.
Since the March lows, for example, according to Ford Equity, the 20 percent of stocks with smallest market capitalizations have on average outperformed the largest 20 percent by 72 percentage points — only slightly less than the 85-point disparity between the lowest- and highest-quality issues. By contrast, in the first nine months of all bull markets since 1926, the average outperformance of the small-cap sector was just 21 percentage points, or less than one-third as much as the disparity over the last nine months, according to calculations by The Hulbert Financial Digest.
Only once since 1926 have the first nine months of a bull market produced a gap greater than this year’s. That was in the bull market that began in February 1933, in the middle of the Great Depression, when small caps outperformed large caps by an incredible 196 percentage points. How can we explain the current extreme performance disparity? The federal government’s stimulus program is the main cause, in the view of Jeremy Grantham, the chief investment strategist at GMO, a money-management firm based in Boston.
Mr. Grantham said in an interview that by temporarily reducing the danger of incurring risk, the government had effectively encouraged huge amounts of risk-taking in financial markets. "The sizable disparity of junk over quality should not have come as a big surprise," he said, "given how massive the government’s stimulus has been." As an unintended consequence, Mr. Grantham said, high-quality stocks today are about as cheap as they have ever been relative to shares of firms with weaker finances. "It’s almost a certain bet that high-quality blue chips will outperform lower-quality stocks over the longer term," he said.
80% Chance Of A Market Crash In The Next Year
The following is an excerpt from fund manager John Hussman's weekly letter. You can read the whole thing here.
I noted last week that from a Bayesian perspective, I would estimate a probability of nearly 80% that we will observe a second round of credit losses coupled with a market plunge in the coming year or so. That doesn't imply an all-out “crash,” but more likely a retreat similar in size to what we have often observed following other post-crash rebounds (about -28% on average).
Of course, from the standpoint of compounding, a 28% decline converts a 60% gain to a more modest 15% net advance, so even without an outright “crash,” it would not be surprising to see the majority of the gains since the March low wiped out. Most likely, we may see a few more years of sideways movement after that, as the economy absorbs the full weight of adjustment to the deleveraging of bad debt and massive increase in government liabilities that we have on our hands.
Suffice it to say that I do not anticipate a V-shaped recovery, and while the stock market may very well recover faster than the rest of the economy, I don't expect durable market gains until after the second wave of losses shakes out.
On the subject of credit delinquencies, the latest report by Trepp (which provides independent research on commercial mortgage-backed securities) indicates that delinquencies on multifamily CMBS loans rose to 8.78 percent in November, up from 7.66 percent the previous month. Commercial delinquencies in retail, industrial and office loans increased as well. The largest jump in delinquencies was in the hotel sector, where the delinquency rate shot to 14.09 percent, from 8.67 percent in October. The data from the banking sector also shows no abatement...
Estimated TARP Cost Is Cut by $200 Billion
The Obama administration, buoyed by a resurgent Wall Street, plans to cut the projected long-term cost of the Troubled Asset Relief Program by more than $200 billion, in a move that could smooth the way for the introduction of a new jobs program. The White House and leaders in Congress are debating whether to use any of the remaining TARP funds for other domestic efforts, such as a jobs bill. Congress authorized $700 billion for the program during the height of the financial crisis.
The Treasury now estimates that over the next 10 years TARP will cost $141 billion at most, down from the $341 billion the White House projected in August. The reduction stems in large part from faster-than-expected repayments by some of the nation's largest banks, as well as less spending on programs to help shore up the financial sector. The government's efforts appear to have helped stabilize the financial sector, and banks have already repaid the Treasury about $70 billion. Bank of America Corp. has said it will return its $45 billion investment as early as this week, and the government now expects total repayments to reach as much as $175 billion by the end of next year. Altogether, it invested $204 billion in 690 firms. The Treasury has also collected more than $10 billion in interest and dividend payments from firms in which it has invested.
The lower-than-expected TARP losses could help the White House tap remaining funds for a jobs program because the revised estimates will help bring down the projected federal budget deficit since the White House will be able to assume less spending associated with the program. The White House has been under pressure to tame the $1.4 trillion budget deficit, which has ballooned as the U.S. borrows vast sums of money. But with unemployment at 10%, the administration is also under pressure to find ways to create new jobs. Lowering deficit projections could help alleviate concerns that a new jobs bill would further inflate the deficit.
President Barack Obama is expected to raise the idea of using repaid TARP funds for a jobs bill in a speech he plans to give on Tuesday. On Friday, White House press secretary Robert Gibbs acknowledged that repaid bailout money is "certainly being looked at" for a jobs bill. Many Republicans are opposed to recycling TARP funds for a jobs bill, calling instead for the money to go toward reducing the deficit. House Minority Leader John A. Boehner (R., Ohio), on Bloomberg television Friday, called it "the worst idea" he had ever heard.
Why Treasury Needs a Plan B for Mortgages
by Gretchen Morgenson
After months of playing pretend, the Treasury Department conceded last week that the Home Affordable Modification Program, its plan to aid troubled homeowners by changing the terms of their mortgages, was a dud. The 10-month-old program is going nowhere, the Treasury said, because big institutions charged with implementing it are dragging their feet.
"The banks are not doing a good enough job," said Michael S. Barr, assistant Treasury secretary for financial institutions, in an article published last Sunday in The New York Times. After the government spent hundreds of billions of dollars bailing out banks, the Obama administration rolled out the $75 billion loan modification plan to show its support for beleaguered homeowners. But if the proof of the pudding is in the eating, homeowners are going hungry.
A stalled loan modification plan might not be worrisome if the foreclosure crisis were abating. Yet at the end of September, a record 14.4 percent of borrowers were either in foreclosure or delinquent on their mortgages, the Mortgage Bankers Association reported. It’s time for the government to acknowledge the flaws in its program and create one that might actually succeed. Only then will the supply of homes for sale, and the pressure on prices associated with that overhang, be reduced.
The Treasury program has decided to tackle the delinquent mortgage problem by reducing the interest rate on eligible borrowers’ loans to a level that makes monthly payments affordable. But how it calculates affordability is one of the program’s major flaws — at least that’s the view of Laurie Goodman, senior managing director at Amherst Securities Group and head of mortgage strategy at the firm. Her research shows, for instance, that 70 percent of modifications involving only interest rate cuts, rather than reductions in the principal borrowers owe, have failed after 12 months. The Treasury program is likely to have similar outcomes.
According to government investigators, the average monthly mortgage payment for a borrower under early plan modifications fell by 34 percent. Assessing for possible success under these terms, Ms. Goodman analyzed past redefault rates on modifications that cut payments by 34 percent. She found that 65 percent of borrowers fell back into delinquency. The terms of loan modifications also make them especially failure-prone because the government calculates "affordability" (how much mortgage debt a borrower can actually manage) in a highly unusual way — raising serious questions for the housing market over all and for the program’s effectiveness for borrowers.
Moreover, investors in first liens, like pension funds and mutual funds, also get beaten up in this process. For example, in devising what it considers an affordable mortgage payment, the program doesn’t account for all of a borrower’s debts — the first mortgage, second lien, credit card debt and automobile payments. Instead, it calculates affordability using only the borrower’s first mortgage payment, insurance and property taxes. As a result, what may look like an affordable mortgage payment under the Treasury plan quickly becomes onerous when other debt is added. While the government may ignore a borrower’s second lien and revolving credit obligations, you can be sure the creditors that extended those loans will not. Redefaults seem a likely result.
Another flaw in the program, Ms. Goodman said, is its failure to consider how much equity, or negative equity for that matter, the borrower has on a property. She said that while many analysts contend that unemployment is the major predictor of mortgage defaults, her research shows that negative equity, when a borrower owes more on the home than it is worth, is actually the driving force.
Ms. Goodman recently compared the experiences of prime mortgage borrowers living in areas with an 8 percent unemployment rate. Those with at least 20 percent equity in their properties were falling two payments behind for the first time at a rate of only 0.22 percent a month. But the same 60-day delinquency rate for those who owed at least 120 percent of the value of their homes was 1.46 percent a month.
"We have kicked the problem down the road through modifications that don’t work," Ms. Goodman said in an interview last week. "You have to address the second liens and ultimately have some type of principal write-down program so borrowers can re-equify." Unfortunately, there is a $442 billion reason that wiping out second liens is not high on the government’s agenda: that is the amount of second mortgages and home equity lines of credit on the balance sheets of Bank of America, Wells Fargo, JPMorgan Chase and Citigroup. These banks — the very same companies the Treasury is urging to modify loans that they service — have zero interest in writing down second liens they hold because it would mean further damage to their balance sheets.
Say a troubled borrower has a first mortgage owned by a pension fund in a securitization trust and a second lien held by the bank that services the loans. The servicer is happy to modify the first mortgage under the Treasury program because the pension fund holding that loan takes the biggest hit while the second lien is untouched. This hurts the investor who holds the first mortgage and the borrower, who must pay off the second lien, which typically has a significantly higher interest rate.
The result? Yet another conflict of interest enriching financial companies while impoverishing investors and consumers. An interesting data point: when banks do own all the mortgages on a property they seem to see the merit in principal reduction modifications. Studying second-quarter government data, the most recent available, Ms. Goodman found that when banks owned the loans, 30.5 percent of modifications reduced principal balances. When they service someone else’s loan or hold a second lien on the property, they rarely allow principal reductions.
Of course, cries of moral hazard will erupt if borrowers get large cuts in their principal balances. Rightly so. Why should those who took on too much debt to buy too much house get rescued when those who were prudent go unrewarded? But doing nothing also has hazards, the most obvious being continuing foreclosures, which nobody wants, and further declines in real estate prices that will hurt homeowners as well as investors.
Gold Can’t Beat Checking Accounts 30 Years After Peak
Gold’s best year in three decades has yet to match the returns of an interest-bearing checking account for anyone who bought the most malleable of metals coveted for at least 5,000 years during the last peak in January, 1980. Investors who paid $850 an ounce back then earned 44 percent as gold reached a record $1,226.56 on Dec. 3 in London. The Standard & Poor’s 500 stock index produced a 22-fold return with dividends reinvested, Treasuries rose 11-fold and cash in the average U.S. checking account rose at least 92 percent. On aninflation-adjusted basis, gold investors are still 79 percent away from getting their money back.
"You give up a lot of return for the privilege of sleeping well at night," said James Paulsen, who oversees about $375 billion as chief investment strategist at Wells Capital Management in Minneapolis. "If the world falls into an abyss, gold could be a store of value. There is some merit in that, but you can end up holding too much gold waiting for the world to end. From my experience, the world has not ended yet." While gold’s nine-year bull market is attracting hedge-fund managers John Paulson, Paul Tudor Jones and David Einhorn, strategists and fund managers at Barclays Plc, HSBC Holdings Plc, SCM Advisors LLC and Brinker Capital Inc. say buy-and-hold investors shouldn’t always own bullion. The accumulation of gold is part of a record $60 billion Barclays estimates will flow into commodities this year.
The SPDR Gold Trust, the biggest exchange-traded fund backed by bullion, has amassed more metal than Switzerland’s central bank, spurred by a plunging dollar and concern that the at least $12 trillion of government spending to lift economies out of the worst global recession since World War II will spur inflation. The collapse of U.S. real estate in 2007 froze credit markets and left the world’s biggest financial companies with $1.72 trillion of losses and writedowns, data compiled by Bloomberg show.
The U.S. Mint suspended production last month of some American Eagle coins made from precious metals because of depleted inventories. The U.K.’s Royal Mint more than quadrupled production of gold coins in the third quarter. Harrods Ltd., the London department store, began selling gold bars and coins for the first time in October. Those sales contributed to a 30 percent rally in gold this year, beating the 25 percent gain in the S&P 500, with dividends reinvested, and a 2.4 percent drop in Treasuries. Investors bought gold as the U.S. economy, the world’s biggest, shrank 3.8 percent in the 12 months ended in June, the worst performance in seven decades. Gross domestic product expanded at a 2.8 percent annual rate in the third quarter.
A weakening dollar also contributed to bullion’s longest winning streak since at least 1948. The U.S. Dollar Index, a measure against six counterparts, dropped in six of the last eight years, including a 6.6 percent decline in 2009, bolstering demand for a hedge. Gold fell 1.6 percent to $1,143 an ounce by 11:08 a.m. in London. Before today, the metal had risen 32 percent this year, the most since 1979. Buy-and-hold investors may not have done so well. One dollar put into a U.S. checking account in 1983 would be worth at least $1.92 today, based on annual average interest rates from Bankrate.com. The Federal Reserve target rate from 1980 to 1982 was 8.5 percent to 20 percent. Banks were paying 5 percent on the accounts in January 1981, according to a report in the New York Times.
The S&P 500 returned 2,182 percent from the beginning of 1980 through the end of the third quarter this year, according to data compiled by Bloomberg. The calculation assumes dividends reinvested on a gross basis. Treasuries returned 1,089 percent through the beginning of this month, according to Merrill Lynch’s Treasury Master Index. "Gold is a useless asset to hold long term," said Charles Morris, who manages more than $2 billion at HSBC Global Asset Management’s Absolute Return fund in London. "I’m not a gold bug who believes that you want to own this thing in your portfolio at all times. We should own it when the going is good, and the going right now is great."
Those who bought gold when it reached a two-decade low of $251.95 in August 1999 have seen a 387 percent return, more than four times the 82 percent gain in Treasuries. An investment in the S&P 500 lost 0.4 percent through the end of last month. Interest on checking accounts shrank to 0.14 percent this year from 0.89 percent in 1999. Since the S&P 500 peaked in October 2007, investors in the index lost 25 percent, holders of Treasuries made 16 percent and gold buyers are up 64 percent.
"There are people that just stayed in very conservative investments in cash and government bonds," said Larry Hatheway, global head of asset allocation at UBS AG in London, who recommends investors hold about 1 percent of their assets in bullion. "Surely they would have been a lot better off being in gold." Buying bullion at $35 when U.S. President Richard Nixon abandoned the gold standard in 1971 would have given a 35-fold return, about the same performance as the S&P 500.
Gold will average $1,070 next year, according to the median in a Bloomberg survey of 19 analysts. The metal may jump to $2,000 in the next five years, said HSBC’s Morris. Ian Henderson, manager of $5 billion at JPMorgan Chase & Co., said he’s adding to his gold-related holdings because of "the momentum behind it." Jim Rogers, the investor who predicted the start of the commodities rally in 1999, has said bullion will surge to at least $2,000 over the next decade. "Our sense is that this bubble is more at the beginning stages than on the brink of collapse," said Thomas Wilson, head of the institutional and private client group at Brinker Capital in Berwyn, Pennsylvania, which manages about $8.5 billion.
Touradji Capital Management LP, the New York hedge fund founded by Paul Touradji, bought 2.23 million shares of Barrick Gold Corp., the world’s biggest producer, during the third quarter, according to a Nov. 13 filing with regulators. The stake, Touradji’s biggest equity holding, is worth $95 million. Paulson & Co., the hedge-fund firm run by billionaire Paulson, will start a gold fund on Jan. 1 investing in mining companies and bullion-related derivatives, according to a person familiar with the plan. Einhorn, who runs New York-based Greenlight Capital Inc., told a presentation in New York in October that he’s buying gold to bet against the dollar.
Paul Tudor Jones, in an Oct. 15 letter to clients of his Tudor Investment Corp., said gold is "just an asset that, like everything else in life, has its time and place. And now is that time." Central banks will become net buyers of gold this year for the first time since 1988, according to New York-based researcher CPM Group. India, China, Russia, Sri Lanka and Mauritius have all added to their reserves. Gold should be held when governments cease to function and currencies are worthless, or when inflation is surging, said Brian Nick, a New York-based investment strategist at Barclays Wealth, which manages $221 billion. He doesn’t recommend increasing gold holdings, which are a "very small" part of commodity allocations.
Inflation has yet to accelerate. U.S. consumer prices will rise 2 percent next year, the smallest expansion since 2002, according to the median estimate of 63 economists surveyed by Bloomberg. Prices will shrink 0.4 percent this year. "People have this knee-jerk reaction and say that you want gold as a hedge against inflation," said Maxwell Bublitz, who helps oversee $3.5 billion as the chief strategist at San Francisco-based SCM Advisors LLC and recommends investors hold no more than 5 percent of their assets in the metal. "But the history of gold in regard to inflation shows that it’s not a great hedge."
Investors seeking to protect themselves against inflation should buycommodities, which are cheaper than gold, said Wells Capital’s Paulsen. Copper, after more than doubling this year, is still 28 percent away from the record $8,940 a metric ton reached in July 2008. "Theoretically, it does have a spot in portfolios, a small one," Bublitz said. "You’re probably going to get entry points that are a lot better than where gold is now."
Dollar Hits One-Month High; Waiting for Bernanke
The dollar hit a one-month high against a basket of currencies, as investors stepped up bets that improved labor market data may prompt the Federal Reserve to lift key interest rate sooner than previously estimated. Demand for the greenback is likely to continue until investors get a better assessment of the implication of a faster recovery in the U.S. labor market in terms of future actions by Fed on interest rates. That may come as soon as 12:45 p.m. EST, when Federal Reserve chairman Ben Bernanke speaks at Economic Club of Washington.
Early Monday in New York trading, the euro was at $1.4788 from $1.4846 late Friday. The dollar was at 90.07 yen, from 90.51 yen, while the euro was at 133.22 yen, from 134.37 yen. The U.K. pound was at $1.6347 from $1.6449. The dollar was at 1.0219 Swiss francs, from 1.0170 francs. The Dollar Index, which tracks the greenback against a trade-weighted basket of currencies, was at 75.981 from 75.788. During overnight trading, the Dollar Index climbed as far as 76.183, the highest level since Nov. 4.
The better-than-expected November non-farm payroll data released Friday fueled speculation that the Fed may begin signaling the end of ultra-low interest rates. "The market will be looking to Bernanke's speech to provide some clarity on whether the November payrolls release really has brought forward the first rate hike of the cycle and whether the dollar could be close to turning around," Jane Foley, a research director at Forex.com in London, wrote in a note to clients Monday.
For most of 2009, the paradigm in the currency markets had been that "good economic data was bad for the dollar" as investors, hopeful of a faster global economic recovery, snapped up growth-sensitive assets such as stocks and higher-yielding currencies, and shunned the low-yielding greenback. The Fed has has kept interest rates at near-zero to help pull the U.S. economy from its worst recession since World War II. Investors have focused on the language in Fed statements following recent rate-setting meetings, particularly its remarks that interest rates would remain low for an "extended period," to gauge when rates may be lifted again.
Ultra-low U.S. interest rates have weighed on the dollar, as investors use cheap dollars to fund bets in riskier assets, such as the euro and other higher-yielding currencies. "The reaction to Friday's jobs data, so far, appears to have been a catalyst for market participants to trim some of their risk on trades," wrote Brown Brothers Harriman strategists. "[Monday's] speech by Bernanke could damp some of that enthusiasm with the Chairman acknowledging the firm jobs data but warning that one month's number does not make a trend, that there are limited signs of inflation and still downside risks to growth," they wrote.
The much-smaller-than-expected drop in non-farm payrolls also stoked the debate of whether the recent links between the dollar and riskier assets to economic data. "Friday's strong jobs report significantly reduces the risk that the dollar will sell off sharply into year-end. However, we do not think that the release will mark a broader turning point for the U.S. currency and that risks will rise again early in the new year," Credit Suisse strategists wrote in a note to clients today.
Fresh Pay Skirmish Erupts at AIG
Five high-ranking executives at American International Group Inc. said last week they were prepared to quit if their compensation is cut significantly by the insurer's government overseers, according to people familiar with the matter. The threat is the latest in the running fracas between AIG and the government's compensation czar, Kenneth Feinberg, who is charged with setting pay limits for top executives at companies receiving the most federal bailout money.
The AIG executives who notified the company they were prepared to resign include its general counsel, Anastasia Kelly, and the heads of some of its largest insurance businesses. Over the weekend, two of them changed their minds. The executives are worried that their 2009 pay will be clipped, and that they will be subject to even tougher restrictions in 2010, including a prohibition against collecting so-called golden-parachute severance payments that they are currently eligible for.
AIG's recently hired chief executive, Robert Benmosche, threatened to quit last month amid frustrations over limitations on pay for top AIG executives. He argued that if the government wants AIG to prosper and pay back its debts, it needs to hire and keep top talent. He subsequently agreed to stay. It doesn't appear that Mr. Benmosche had anything to do with last week's threatened departures, people familiar with the matter say.
AIG is 80% owned by the U.S. government, which has committed $182 billion in financial support to the firm. As one of the biggest recipients of government aid, AIG is subject to Mr. Feinberg's pay decisions. In October, Mr. Feinberg reduced 2009 compensation for AIG's top 13 employees by 57%, including limiting most base salaries to no more than $500,000. Those 13 executives were the ones who remained of the 25 top 2009 earners at AIG, whose pay Mr. Feinberg was ordered to review. The others left before the pay review began. Mr. Feinberg is currently working on pay structures for the next 75 highest-paid AIG employees. The five senior staff members who said they may leave fall into that category.
Mr. Feinberg is considering less restrictive compensation for those 75, as well as for the top 100 earners in 2010, according to people familiar with the matter. Mr. Feinberg and AIG are discussing a plan under which the firm could pay individuals more than $500,000 as long as it can show "good cause" for going higher. Some Treasury Department and Federal Reserve officials have urged Mr. Feinberg to ease up on the cuts. The five senior AIG executives indicated on Dec. 1, in written notices, that they're prepared to leave by year-end, say the people familiar with the matter. They are trying to preserve their ability to collect severance payments, these people say.
Ms. Kelly, AIG's general counsel, has been at the insurer since 2006 and was appointed vice chairman in January under former CEO Edward Liddy. Several people familiar with the matter say Ms. Kelly asked other employees to join her in indicating they were prepared to resign. Four executives agreed, and Ms. Kelly retained outside counsel to advise the group on their legal options, says one person familiar with what happened. A spokesman for Ms. Kelly says she didn't "instigate or encourage" the other four, but "only advised the other executives of what they needed to do to protect their rights" under AIG's executive-severance plan, and helped them arrange for outside counsel.
The other four executives are Rodney Martin, who heads one of AIG's international life-insurance businesses that is slated for an initial public offering or sale; William Dooley, who has been overseeing the financial-services division; Nicholas Walsh, vice chairman and head of AIG's international property-and-casualty-insurance businesses; and John Doyle, who heads the U.S. property-casualty business. Mr. Dooley's division includes AIG Financial Products, whose credit-derivative trades were the biggest reason for AIG's 2008 financial problems. The other four executives weren't involved in the problems that sank the company.
Over the weekend, Messrs. Walsh and Doyle rescinded their Dec. 1 notices, a person familiar with the matter said. Messrs. Martin, Dooley, Walsh and Doyle either declined to comment or didn't respond to requests for comment. According to terms of the severance plan, which was put in place before the government bailed out AIG, certain executives are entitled to severance benefits if they resign for "good reason," which includes significant cuts in their annual base salary or target bonus.
The provision applies to roughly two dozen individuals, says one person familiar with it. The five who said they might quit "gave notice that they believe they have 'good reason' to resign" under the provision, and they are "taking administrative action to protect their rights because of all the uncertainty" around pay matters, this person says. With the resignations of nearly half of AIG's top 25 earners in 2009, some of the next 75 highest earners will be bumped into the top 25 next year. That would subject them to tougher restrictions and make them ineligible for severance benefits.
Earlier this year, Congress imposed restrictions on firms receiving large amounts of federal aid, including prohibiting "golden parachute" payments to some top executives. Mr. Feinberg is expected to issue his determinations for AIG within the next two weeks. Government officials say Mr. Feinberg, who oversees pay at seven firms receiving large amounts of government aid, is in a tough spot. He's charged with both curbing pay and preserving the ability of the firms to retain key personnel.
Three Strikes on Ben Bernanke: AIG, Goldman Sachs & BAC/TARP
by Chris Whalen
On Saturday, joined by hundreds of friends, family and colleagues on a snowy December day in Yonkers, NY, we celebrated the life of Mark Pittman. Readers of The IRA who wish to express their thanks to Mark and show support for his family may make contributions to the Pittman Children’s College Fund, c/o Dr. William Karesh, 30B Pondview Road, Rye, NY 10580.
Bob Ivry from Bloomberg News gave a remembrance of Mark, including reading the letter that his daughter Maggie Pittman posted on zerohedge to dispel rumors that her dad might have been murdered. Some members of the zerohedge family thought that Mark was killed by the banksters for his diligent pursuit of the disclosure of the Fed’s many bailout loans to Wall Street firms.
Ivry also told a great story of how, when asked by a younger reporter why she should give Pittman her scoops instead of giving them to CNBC’s Charlie Gasparino, Mark replied: “I’m taller than Charlie and can see above the bullshit.” We miss Mark a lot.
Coming together with the friends of Mark Pittman ended a grim week. Many of us in the financial community were wading hip-deep through barnyard debris as we watched Federal Reserve Chairman Bernanke dodge and weave in front of the television cameras during his Senate confirmation hearing. We have to believe that Mark would have been pleased as Senators on both sides of the aisle asked questions that came directly from some of his reporting — and a few of our own suggestions.
To us, the confirmation hearings last week before the Senate Banking Committee only reaffirm in our minds that Benjamin Shalom Bernanke does not deserve a second term as Chairman of the Board of Governors of the Federal Reserve System. Including our comments on Bank of America (BAC) featured by Alan Abelson this week in Barron’s, we have three reasons for this view:
First is the law. The bailout of American International Group (AIG) was clearly a violation of the Federal Reserve Act, both in terms of the “loans” made to the insolvent insurer and the hideous process whereby the loans were approved, after the fact, by Chairman Bernanke and the Fed Board. The loans were not adequately collateralized. This is publicly evidenced by the fact that the Fed of New York (FRBNY) exchanged debt claims on AIG itself for equity stakes in two insolvent insurance underwriting units. What more need be said?
As we’ve noted in The IRA previously, we think the AIG insurance operations are more problematic than the infamous financial products unit where the credit default swaps pyramid scheme resided. And we doubt that any diligence was performed by Geither and/or the FRBNY staff on AIG prior to the decision taken by Tim Geithner to make the loan. We’ll be talking further about AIG in a future comment.
Of interest, members of the Senate Banking Committee who want more background on the AIG fiasco, particularly who did what and when, need to read the paper by Phillip Swagel, “The Financial Crisis: An Inside View,” Brookings Papers on Economic Activity, Spring 2009, The Brookings Institution. We hear in the channel that Fed officials were furious when Swagel, who served at the US Treasury with former Secretary Hank Paulson, published his all-too-detailed apology. We understand that several prominent members of the trial bar also are interested in the Swagel document.
Last week the Senate Banking Committee spent a lot of time talking with Chairman Bernanke about why payouts were made to AIG counterparties like Goldman Sachs (GS) and Deutsche Bank (DB), but the real issue is why Tim Geithner and the GS-controlled board of directors of the FRBNY were permitted to make the supposed “loans” to AIG in the first place. The primary legal duty of the Fed Board is to supervise the activities of the Reserve Banks. In this case, Chairman Bernanke and the rest of the Board seemingly got rolled by Tim Geithner and GS, to the detriment of the Fed’s reputation, the financial interests of all taxpayers and due process of law.
Martin Mayer reminded us last week that the Fed is meant to be “independent” from the White House, not the Congress from which its legal authority comes by way of the Constitution. Nor does Fed independence mean that the officers of the Federal Reserve Banks or the Board are allowed to make laws. None of the officials of the Fed are officers of the United States. No Fed official has any power to make commitments on behalf of the Treasury, unless and except when directed by the Secretary. Given the losses to the Treasury due to the Fed’s own losses, this is an important point that members of the Senate need to investigate further.
The FRBNY not only used but abused the Fed’s power’s under Section 13(3) of the Federal Reserve Act. In AIG, the FRBNY under Tim Geithner invoked the “unusual and exigent” clause again and again, but there is a serious legal question whether the then-FRBNY President and the FRBNY’s board had the right to commit trillions without any due diligence process or deliberate, prior approval of the Fed Board in Washington, as required by law. The financial commitments to GS and other dealers regarding AIG were made always on a weekend with Geithner “negotiating” alone in New York, while Chairman Bernanke, Vice Chairman Donald Kohn and the rest of the BOG were sitting in DC without any real financial understanding of the substance of the transactions or the relationships between the people involved in the negotiations.
Was Tim Geithner technically qualified or legally empowered to “make deals’ without the prior consent of the Fed Board? We don’t think so. Shouldn’t there have been financial fairness opinions re: the transactions? Yes.
We understand that the first order of business in any Fed audit sought by members of the Senate opposed to Chairman Bernanke’s re-appointment is to review the internal Fed legal memoranda and FRBNY board minutes supporting the AIG bailout. These documents, if they exist at all, should be provided to the Senate before a vote on the Bernanke nomination. Indeed, if the panel established to review the AIG bailout and related events investigates the issue of how and when certain commitments were made by the FRBNY, we wouldn’t be surprised if they find that Geithner acted illegally and that Bernanke and the Fed Board were negligent in not stopping this looting of the national patrimony by Geithjner, acting as de facto agent for the largest dealer banks in New York and London.
The second strike against Chairman Bernanke is leadership. In an exchange with SBC Chairman Christopher Dodd (D-CT), Bernanke said that he could not force the counterparties of AIG to take a haircuts on their CDS positions because he had “no leverage.” Again, this goes back to the issue of why the loan to AIG was made at all. Having made the first error, Bernanke and other Fed officials seek to use it as justification for further acts of idiocy. Chairman Dodd look incredulous and replied “you are the Chairman of the Federal Reserve,” to which Bernanke replied that he did not want to abuse his “supervisory powers.” Dodd replied “apparently not” in seeming disgust.
We have been privileged to know Fed chairmen going back to Arthur Burns. Regardless of their politics or views on economic policies, Fed Chairmen like Burns, Paul Volcker and even Alan Greenspan all knew that the Fed’s power is as much about moral suasion as explicit legal authority. After all, the Chairman of the Fed is essentially the Treasury’s investment banker. In the financial markets, there are times when Fed Chairmen have to exercise leadership and, yes, occasionally raise their voices and intimidate bank executives in the name of the greater public good. AIG was such as test and Chairman Bernanke failed, in our view.
Chairman Bernanke does not seem to understand that leadership is a basic part of the Fed Chairman’s job description and the wellspring from which independence comes. The handling of AIG by Chairman Bernanke and the Fed Board seems to us proof, again, that Washington needs to stop populating the Fed’s board with academic economists who have no real world leadership skills, nor operational or financial experience. Just as we need to end the de facto political control of the banksters over America’s central bank, we need also to end the institutional tyranny of the academic economists at the Federal Reserve Board.
The third reason that the Senate should vote no on Chairman Bernanke’s second four-year term as Fed Chairman is independence. While Bernanke publicly frets about the Fed losing its political independence as a result of greater congressional scrutiny of its operations, the central bank shows no independence or ability to supervise the largest banks for which it has legal responsibility. And Chairman Bernanke has the unmitigated gall to ask the Congress to increase the Fed’s supervisory responsibilities. As we wrote in The IRA Advisory Service last week:“Indeed, if you want a very tangible example of why the Fed should be taken out of the business of bank supervision, it is precisely the TARP repayment by Bank of America. The responsible position for the Fed and OCC to take in this transaction is to make BAC raise more capital now, when the equity markets are receptive, but wait on TARP repayment until we are through Q2 2010 and have a better idea on loss severity for on balance sheet and OBS exposures, HELOCs and second lien mortgages, to name a few issues. Apparently allowing outgoing CEO Ken Lewis to take a victory lap via TARP repayment is more important to the Fed than ensuring the safety and soundness of BAC.”
One close observer of the mortgage channel, who we hope to interview soon in The IRA, says that given the recent deterioration of mortgage credit, it is impossible that BAC has not gotten its pari passu portion of the losses which are hitting the FHA. The same source says that using conservative math, FHA has another $75 billion in losses to take, with zero left in the FHA insurance fund. Worst case for FHA is double that number, we’re told. How could the Fed believe that BAC, which is the biggest owner of mortgages and HELOCs, is immune from this approaching storm? Because the Fed is cooking the books of the largest banks.
The observer confirms our view that trading gains on the books of banks such as BAC are due to the Fed’s open market purchases, which drove up prices for MBS and other types of toxic waste. In effect, the Fed’s manipulation of the prices of various toxic securities is giving the largest US banks and their auditors a “pass” on accounting write-downs in Q4 2009 and for the full year – assuming that MBS prices do not drop sharply before the end of the month.
Question: Is not the Fed’s manipulation of securities prices and the window-dressing of bank financial statements not a vioatlion of securities laws and SEC regulations?
Of note, in her column on Sunday about the widely overlooked issue of second lien mortgages, “Why Treasury Needs a Plan B for Mortgages,” Gretchen Morgenson of The New York Times writes that “Unfortunately, there is a $442 billion reason that wiping out second liens is not high on the government’s agenda: that is the amount of second mortgages and home equity lines of credit on the balance sheets of Bank of America, Wells Fargo, JPMorgan Chase and Citigroup. These banks – the very same companies the Treasury is urging to modify loans that they service – have zero interest in writing down second liens they hold because it would mean further damage to their balance sheets.”
Thus the Fed is not only allowing insolvent zombie banks to repay TARP funds before the worst of the credit crisis is past, but the “independent” central bank is engaged in a massive act of accounting fraud to prop up prices for illiquid securities and thereby help banks avoid another round of year-end write downs, the banks the Fed supposedly regulates. This act of deliberate market manipulation suggests that the Fed’s bank stress tests were a complete fabrication. Only by artificially propping up prices for illiquid securities can the Fed make the banks look good enough to close their books in 2009 and, most important, attract private equity investors back to the table.
Of note, the perversion of accounting rules in the name of helping the largest global banks is also well-underway in the EU. Our friends at CFO Zone published a comment on same last week that deserves your attention: “International Accounting Standards Board has ‘disgraced itself,’ says critic”
What is really funny, to us at least, is that we hear in the channel that BAC is ultimately going to give the CEO slot to a BAC insider, consumer banking head Brian Moynihan, who testified before Congress on the Merrill Lynch transaction in November. Just imagine how the Fed Board, Chairman Bernanke and the Fed’s Division of Supervision & Regulation are going to look when, after all the hand wringing about aiding BAC’s CEO search by allowing the TARP repayment, the post is finally given to an insider!
Former colleagues describe Moynihan as a close associate of Ken Lewis. If the objective of forcing Lewis’ departure was change in the culture in the CSUITE at BAC, installing one of his trusted henchmen, in this case left over from the Fleet Bank acquisition, seems a retrograde step.
All we can say about the treatment of the BAC TARP repayment issue and the Fed’s handling of the supervision of large banks generally is that it is high time for the Congress to revisit the McFadden Act of 1927. In particular, we need to look again at making further changes to the Fed to ensure that it is entirely subordinate to the public interest and that never again will private financial institutions such as GS or BAC be in a position to dictate terms to the central bank. Whether you are talking about the loans to AIG or the mishandling of BAC’s TARP repayments, the Fed under Chairman Bernanke seems to have acted irresponsibly and contrary to the law.
For all of the above reasons, we think that the Senate should reject the re-nomination of Ben Bernanke and ask the President to nominate a new candidate as Chairman and also nominate two additional candidates for Fed governor to fill the other two long vacant seats.
China's top economic planners meet to fine tune policies
China's top economic planners were meeting Monday in an annual session said to be focused on fine-tuning policies to ensure the recovery is sustained. The gathering in Beijing, headed by President Hu Jintao, began Saturday and was expected to wrap up later Monday with a pledge to keep in place stimulus policies aimed at preventing a relapse of the downturn, with adjustments to reflect mounting worries over excess investment in some industries, media reported.
A year after the country launched a 4 trillion yuan ($586 billion) stimulus package aimed at countering the impact of slumping exports, economists say they expect growth for the year to exceed the government's target of 8 percent. This year's meeting also was expected to include preliminary work on the country's next five-year plan, for the years 2011-2015.
Late last month, the country's policy makers indicated they planned to stick to stimulus spending and easy credit to ensure growth is sustained despite weakness in the US and other key export markets. The emphasis, however, is shifting to promoting consumer spending and private investment, rather than the state-led investment of this year's recovery program, which has focused heavily on construction of railways, roads and other public works, newspaper China Business News and other reports said.
China's economy grew 8.9 percent over a year earlier in the third quarter of this year, after dipping to a 12-year low of 6.1 percent in the first quarter, a stunning rebound from last year's slowdown. But the government has struggled to control the expansion of industries viewed as already overheated, such as steelmaking and cement. The rapid credit expansion has added to risks in China's banking sector, the Basel, Switzerland-based Bank for International Settlements warned in a quarterly report issued Sunday.
Apart from the easing of standards to allow banks to issue some 8.95 trillion yuan ($1.3 trillion) in new loans in January-October, up from a total of 4.2 trillion yuan the year before, future tightening of monetary policies might leave some projects short of funds before they are completed, leading to a buildup of bad loans, it said. Meanwhile, inflows of outside capital into the world's fastest growing major economy are adding to inflationary pressures, especially in real estate and stock markets, the BIS report warned.
Darling Weighs Bonus Levy, Scrapping Tax Cut for Rich
Chancellor of the Exchequer Alistair Darling is considering a levy on bankers’ bonuses and this week may reverse a tax cut for Britain’s richest households in an effort to win over voters before next year’s election. Darling yesterday refused to rule out a tax on excessive bonus payments, although he pledged to hold back from measures that would harm Britain’s banks. He said that lowering the inheritance tax for the richest people is no longer a priority for the pre-budget report on Dec. 9.
"We are not going to be held to ransom by people who believe you can pay extremely large bonuses regardless of what’s going on," Darling told BBC television yesterday. "You have to be fair. You have to be reasonable. But you have got to keep an eye on what the long-term effects are." Darling and Prime Minister Gordon Brown are trying prevent bankers awarding themselves large bonuses while the entire British banking system is underpinned by public money. Tougher rhetoric against bankers and the rich is also helping Brown’s Labour Party chip away support from David Cameron’sConservatives ahead of the election.
Bank shares fell in London trading today. Royal Bank of Scotland Group Plc slid 2 percent to 33.95 pence, and Lloyds Banking Group Plc lost 2.3 percent to 54.73 pence. The FTSE 350 Banks Index declined as much as 1.4 percent, the biggest drop in more than a week. The pound weakened against the dollar and the euro. The British currency dropped to $1.6323 as of 12:16 p.m. in London, from $1.6474 at the end of last week. It weakened to 90.59 pence per euro, from 90.18 pence.
Darling said he has not yet seen bonus plans from government-controlledRoyal Bank of Scotland and that he has the power to veto any proposals he considers excessive. Darling has also said that he is opposed to punitive measures that would damage a bank’s capital position, making it less likely that he will introduce an industry-wide windfall tax. "It’s not a black and white world," Darling said.
Instead of the bonus levy, the BBC reported yesterday that the government may impose a one-year windfall tax. Other options may include a larger employers’ national insurance charge or a direct tax on investment banks, the BBC added, citing unnamed ministers and officials. "A 10 percent levy on bank profits would raise around 2 billion pounds," saidVince Cable, a lawmaker who speaks on Treasury matters for the Liberal Democrats. "This is a much more effective solution than a one off levy and recognizes the debt that the banks owe to the taxpayer."
George Osborne, the Conservative lawmaker who shadows Darling in Parliament, told the same program yesterday that he "wouldn’t rule out" a charge on excessive individual bonuses if his party defeats Labour in the election, which has to take place before June. An ICM Research Ltd. poll showed that the Conservatives are on course to obtain a majority of between 20 and 25 seats in the 646-seat House of Commons. A ComRes Ltd. survey Dec. 1 showed that the U.K. may be heading for a hung Parliament where no party has an outright majority, with Cameron leading Brown by 10 percentage points, down 3 points from October.
Darling stepped up the attack yesterday, saying Osborne’s plea to voters to endure tougher times during the worst economic crisis since World War II isn’t consistent with tax cuts for the rich. Cameron is sticking to a similar inheritance tax plan. That strategy has helped Brown’s Labour Party erode Cameron’s lead in opinion polls. A YouGov Plc poll published yesterday showed that more than half of the 2,000 people interviewed viewed the Conservatives as the party of the rich. Cameron said Brown had been "spiteful’ in his efforts to tell voters of his privileged upbringing and elite schooling. "I really can’t believe it would be the first priority of any government, at this time, to give a tax cut to the top 2 percent of estates in this country," Darling said yesterday.
Darling said in 2007 that he would raise the inheritance tax threshold to 350,000 pounds ($578,000) from 325,000 pounds for single people and to 700,000 pounds from 650,000 pounds for couples, starting April 2010. Cameron’s Conservatives want to abolish the tax for single people with estates below 1 million pounds and for couples with estates below 2 million pounds. "If the Labour Party wants to say don’t aspire to get on in life, then so be it,"Osborne said. "It’s part of their lurch to the left."
Darling said this week’s pre-budget statement will spell out some detail on how he plans to implement his pledge to reduce the deficit by as much as half over four years. In the April budget, the Treasury forecast a shortfall of 175 billion pounds in the year through March 2010, or 12.4 percent of gross domestic product -- the largest in British postwar history. Darling told the BBC yesterday that he will scrap a 12.4 billion-pound computer program for the National Health Service that is being developed mainly by iSoft Plc. Similar reductions, rather than staff cuts in schools and hospitals, would indicate "the direction of travel" in this week’s report, he said. "The NHS had quite an expensive IT system and I don’t think we need to go ahead with it now," he said.
Brown said today the government will cut spending by more than 12 billion pounds in the next four years through efficiency gains. Ministers had found 3 billion pounds of new savings since April, including 1.3 billion pounds by "streamlining" central government, he said in a speech in London. Brown said on Dec. 4 in his weekly podcast that a plan to move more government services online would save about 400 million pounds a year.
Today, he promised to reduce the pay bill for senior civil servants by 20 percent over the next three years, and said that more civil service jobs will be moved from London and the southeast of England to parts of the country where living costs are lower. The government will halve spending on consultants and cut its marketing budget by a quarter, Brown said.
'Orphaned' Canadian homeowners face foreclosure
For the past three years, Lisa Matthews has never missed a mortgage payment - handing over $292, like clockwork, every week. But if nothing changes, a bailiff, acting at the request of her mortgage lender, will ring her doorbell and tell Ms. Matthews, her two daughters and her boyfriend to vacate the two-storey house for good.
"This was a pure slap in the face," said Ms. Matthews, a 36-year-old clerk with the City of Hamilton, who was recently told that, despite her perfect payment record, her mortgage will not be renewed at the end of its three-year term. Ms. Matthews is one of many Canadians being abandoned by a breed of alternative lenders that have stopped lending to customers, who, because of poor credit scores, lower-paying jobs, or minimal home equity, couldn't obtain financing from a raditional lender, such as a bank.
Everyone from the chief executive officer of Ms. Matthews' lender, Xceed Mortgage Corp., XMC-T to senior officials in Ottawa, agree that borrowers such as Ms. Matthews, who have dutifully paid their mortgage bills, are being unfairly stranded. What they can't agree on is how many Lisa Matthews are out there.
Records obtained under the Access to Information Act show that a lobby group representing these lenders has warned the federal government that, unless taxpayers offer help, they will be forced to foreclose on as many as 30,000 homeowners over the next three years. These "orphaned mortgages," as the industry is calling them, are held by customers who have impeccable payment histories. But they can't be renewed because the credit crunch has shut off the funding pipeline of non-bank lenders, the lobby says. This wave of forced sales and evictions will hit its crest this coming year when nearly half of these mortgages - most of which were issued during the real estate boom of 2007 - will not be renewed, the mortgage companies say.
Executives with alternative mortgage companies say they cannot renew the stranded mortgages because the once-thriving securitization market that attracted investors to these risky - and lucrative - mortgages collapsed in the wake of the U.S. subprime mortgage crisis. To replace the lost pool of capital, lenders are asking the federal government to back a special billion-dollar fund that would renew the healthy mortgages of borrowers who do not qualify for loans from traditional lenders.
Finance Department officials, however, have responded to the lobby group's alarm bells with caution and questioned their estimates, according to sources close to the negotiations. These sources say Ottawa is frustrated that some of the companies in this small segment of the Canadian mortgage market have been unwilling to hand over data so the problem can be fully assessed, one source said. "The government thinks this group is asking for help for itself," said the official close to the talks, which bogged down this summer. "Had they been willing to co-operate with the government and provide that information, some sort of program could have been designed. But you can't design a program on anecdotes."
The roots of the problem can be traced back to the housing and lending heyday of half a decade ago, when an assortment of "non-conforming," or subprime mortgage lenders launched operations. Some, such as Xceed and Mississauga-based N-Brook Mortgage Group Inc. had roots in Canada, and others, such as San Diego-based Accredited Home Lenders, migrated from the saturated subprime market in the United States.
Many of these mortgage companies aren't federally regulated so, unlike a bank, they aren't required to insure mortgages when the down payment is equal to less than 20 per cent of the value of the home. And unlike banks, they could - and often did - give loans to people who couldn't afford a down payment. After extra fees were piled on, some of these mortgages added up to as much as 104 per cent of the value of the house being purchased. Interest rates hovered as high as 11 per cent. Within a few years, this sort of lending started to explode and the new players quickly took hold of 5 per cent of the Canadian market.
But when the financial crisis struck last year, and "subprime" became a dirty word, the pension funds and investment banks that these companies relied upon to fund their mortgages, spurned them. Investors that previously had a ravenous appetite for securities backed by high-risk mortgages were now demanding their money back from companies like Xceed. These investment windows are closing at a time when thousands of mortgages, like Ms. Matthews' loan, are coming due.
Few of the low-income borrowers who were targeted by alternative lenders gave much thought to where their mortgage money was coming from. "The way we understood it, as long as our mortgage was paid, they would just renew it. The joke was on me," said Joyce Marentette, a cook in Chatham, Ont., who was also told last year by Xceed that she would have to find other financing, when her three-year term came up.
The problem is more acute in depressed areas such as Southwestern Ontario and parts of Alberta, where there are fewer private financiers and property values have sagged, industry insiders say. Mortgage brokers in Ontario cities such as Windsor, Chatham and St. Thomas say they regularly receive frantic phone calls from homeowners who are shocked to receive a letter explaining that their mortgage won't be renewed.
"We're not talking about a scoundrel that brought it upon himself. ... These are people that didn't do anything wrong," said Joel Katz, a Windsor mortgage broker. Mr. Katz said he believes the issue isn't on the government's radar because this type of lending accounted for such a small segment of the market compared with the United States. "The problem wasn't as big here, and there are people who are getting stepped on and overlooked."
But exactly how many people are being "stepped on?" Public records in Canada are so scarce, it's impossible - even for lawmakers - to know for sure. Ottawa relies on Canada Mortgage and Housing Corp. for data, but because none of these subprime players insured their mortgages through CMHC, the public agency knows very little about their state of their books. One source close to the Finance Department said officials at the Crown corporation figure that stranded borrowers account for only "a tiny sliver" of the country's homeowners.
Paul McGill, president of mortgage provider N-Brook and spokesman for the mortgage lenders lobby, argues Ottawa is understating the problem. He said he has supplied federal officials with data showing that $1.7-billion of healthy mortgages could be stranded and that these borrowers lack high enough credit scores to qualify for loans from more conservative lenders.
Mr. McGill said federal officials responded by asking mortgage lenders to supply extensive borrower details such as marital status and garage dimensions. Mr. McGill said the requests would have cost too much time and money to fulfill. Lenders have scaled back their proposal to call for a $1-billion Ottawa-backed fund that could renew stranded mortgages. He said Ottawa has not been supportive. In response to questions, the Finance Department issued a statement saying: "The government is monitoring housing and mortgage markets in order to ensure they remain stable, strong and competitive."
Far away from the push and pull in Ottawa, Ms. Matthews has put her house up for sale. A handful of prospective buyers has wandered through, but she has received no offers. A few weeks ago, she received a letter from Xceed's lawyers, explaining that she owes the company nearly $128,000. This means that, despite paying Xceed about $40,000 over the past three years, she now owes $1,000 more than she originally borrowed. When she opted to buy her first home, she had to get over the hurdle of her low credit score. An unpaid student loan had caught up with her. She had no down payment, and paid a 9.15-per-cent interest rate with Xceed. "I just thought they were my foot in the door," she said.
Ivan Wahl, Xceed's CEO, said his company has identified 1,100 borrowers that his company will maroon over the next three years. For those people "it is an absolute disaster," he said. Despite his sympathy, he says he is contractually obligated to pay Xceed's investors, which means demanding full payment at renewal time. "The government certainly should step up to the plate to provide some facilities for people who got caught in the crunch."
Ms. Matthews said she doesn't expect the government to do anything for her, and is reserving her frustration for Xceed. She said the companies involved should be giving their customers more warning about their inability to renew. She received a warning letter 31/2 months before her mortgage matured. "If I knew it was going to end like this, I never would have done it."
Bank of Canada Rates in House Boom Prompt Bubble Talk
Bank of Canada Governor Mark Carney’s pledge to freeze record-low borrowing costs through June may be raising the chances of a bubble in home prices even as it helps the economy recover from its first recession in 17 years.
Sales of existing houses rose 74 percent in October from the January low, with prices up 21 percent from a year ago to a record C$341,079 ($323,203), partly because of Carney’s promise -- the only date-specific commitment from a Group of 20 central banker. To prevent the economy from overheating, Carney will raise his benchmark rate by 125 basis points to 1.5 percent in 2010, while Federal Reserve Chairman Ben S. Bernanke will keep his key rate at 0.25 percent, said Stephen Gallagher, chief U.S. economist in New York at Paris-based Societe Generale SA.
"The worry has got to be that you might be getting a housing bubble out of this," said David Laidler, a former visiting economist and special adviser at the Bank of Canada and now a fellow at the C.D. Howe Institute, a Toronto research group. Laidler is a member of the institute’s Monetary Policy Council, which studies central-bank decisions and said in a Dec. 3 statement that a "possible unintended effect" of Carney’s commitment is "the buoyancy of mortgage lending, particularly variable-rate mortgages, and the housing market."
For now, analysts at Toronto investment banks Scotia Capital and RBC Capital Markets are recommending investors buy shares of companies such as Home Capital Group Inc., even after the Toronto-based mortgage lender gained 166 percent since its 2009 low on Feb. 11 to C$41.75 as of 9:46 a.m. New York time. "The challenge right now is getting the economy going and dealing with any potential bubbles down the road," said Ian Nakamoto, director of research at MacDougall MacDougall & MacTier Inc. in Toronto, which manages about C$4 billion. Carney’s situation reflects the conundrum faced by policy makers who must weigh the trade-off between stimulating their economies now with ultra-low rates and dealing later with the fallout from unintended consequences.
"It is time to break the daisy chain of asset and credit bubbles and the global imbalances they spawn," Morgan Stanley Asia Chairman Stephen Roach told a conference in Vancouver Dec. 1. "If we fail, there may not be another chance." Carney, 44, has made it clear that stimulus is his priority. Only if the outlook for inflation shifts would the bank break its promise, he has said. "Rates are exceptionally low, they are exceptionally low for a purpose and we have given pretty clear guidance on how long we expect they will have to remain at these levels in order to achieve the inflation target," Carney told reporters Oct. 22. The bank projects the consumer price index, which rose at a 0.1 percent annual pace in October, will reach the target of 2 percent by the second half of 2011.
The central bank hasn’t talked much about house prices, "to the bafflement of international investors," said Eric Lascelles, chief economist and rates strategist with TD Securities Inc. in Toronto. The bank’s next opportunity comes tomorrow in an interest-rate announcement scheduled for 9 a.m. New York time. "It makes perfect sense that there is a good appetite for the housing market," Lascelles said. What isn’t clear is "whether this is a bubble in the making or simply a recovery from earlier softness." The New York-based Trump Organization, founded by real- estate developer Donald J. Trump, is building a 60-story Trump International Hotel & Tower in downtown Toronto. The residential condominiums sell for at least C$2 million.
Canada will be "one of the first markets" that "we’ll look at in the upswing," said Donald Trump Jr., 31, executive vice president of development and acquisitions. Canadians are jumping at "what they perceive as a once-in- a-lifetime opportunity," said Peter Gilgan, 58, founder and chief executive officer of Oakville, Ontario-based Mattamy Homes Ltd., Canada’s biggest homebuilder. The average five-year mortgage rate was 5.59 percent last week. In May it was 5.25 percent, the lowest since 1951 according to Bank of Canada figures.
Sales of existing homes will rise to 492,300 in 2010, up 7 percent from 460,200 this year, according to the Canadian Real Estate Association, an Ottawa trade group -- the second-highest total on record after 520,747 in 2007. Building permits jumped 18 percent in October, led by work on single-family homes and non-residential projects, Statistics Canada said today in Ottawa. The total value of permits issued by municipalities rose to C$6.12 billion, the most since September 2008.
The booming housing market partly reflects the strength of Canada’s financial system, which was named the soundest in the world for two consecutive years by the Geneva-based World Economic Forum. No banks collapsed or sought a bailout during the biggest global credit crunch since the Great Depression. In the U.S., the Treasury Department’s Troubled Asset Relief Program provided a total of about $205 billion in capital injections to banks, according to the department’s most recent report on Nov. 25.
Lending practices at Canadian banks have been more conservative than those of U.S. financial institutions, said Ivan Wahl, chairman and chief executive officer of mortgage provider Xceed Mortgage Corp. Subprime loans accounted for 5 percent at the peak of Canada’s market in the summer of 2007. Even in that segment, default rates are about 3 percent compared with 30 percent in the U.S., he said.
"We’ve never had the traumatic problems," said Wahl, whose Toronto-based company targets customers who have trouble getting mortgages with the largest banks. "We have one of the most constructive, positive and stable real-estate markets in the world." Canada’s economy shrank for three quarters starting at the end of 2008, one period less than in the U.S. Canada’s unemployment rate was 8.5 percent last month compared with 10 percent in the U.S. The 1.5 percentage-point gap was just under October’s 1.6 point difference, which was the widest since at least 1976.
The state of the housing market reflects "an element of pent-up demand," Carney told reporters Nov. 19. "Rates are exceptionally low, affordability has improved in part because of the low level of interest rates and part because of some former price adjustments, and we are seeing a housing-price response."
His view is shared by Peter Aceto, chief executive of Toronto-based ING Direct Canada, a unit of financial-services company ING Groep NV in Amsterdam, that has 1.6 million customers including 125,000 mortgage clients and C$33 billion in assets. "I don’t believe that there’s a bubble," he said. "Most stories I hear are just typical Canadians trying to buy their first home or move up."
Aceto said he is seeing some unusual signs, particularly in the Toronto market, where houses are getting as many as five offers at a time and prospective buyers are trying to woo sellers with personal notes or gifts. "When Canadians are waiving conditions and paying 10 percent more than asking for a home, it does give you some pause," he said. If policy makers are concerned about a possible bubble, they might look to tools other than interest rates to cool the market, said Brian Johnston, 51, president of Monarch Corp. in Toronto, the Canadian division of London-based Taylor Wimpey Plc, the U.K.’s largest homebuilder by market value.
"They might encourage lenders to be a little more circumspect in their mortgage qualifications; they may look at the amortization periods on mortgages," he said. "I don’t think they can control housing through fiddling with interest rates." Last year, the Department of Finance said Canada Mortgage and Housing Corp. would limit amortizations to 35 years and 95 percent of the loan value. The government’s housing agency had offered mortgage insurance on loans worth as much as 100 percent of the home value and amortization periods of as many as 40 years since 2006.
The strong market will help companies such as Brookfield Real Estate Services Fund, said Rossa O’Reilly, a financial analyst at CIBC World Markets in Toronto. O’Reilly raised his rating on Brookfield, which has about 14,500 brokers and agents under brands such as Royal LePage, to sector outperform in July, and in November raised the share target price to C$12.50. It traded at C$11.48 today. The fund is a subsidiary of Brookfield Asset Management Inc., which, along with Simon Property Group Inc., has purchased part of General Growth Properties Inc.’s bank debt and bonds and may make bids for all or part of General Growth, the Wall Street Journal reported last week, citing people familiar with the matter it didn’t identify by name.
Other industries will also benefit, notably appliance and furnishing manufacturers and retailers including Boucherville, Quebec-based Rona Inc., O’Reilly said. Shares of Canada’s largest home-improvement chain have returned 22 percent this year, lagging a 31 percent return for Canada’s benchmark stock index. Rona shares were unchanged at C$15.26 today.
Paul Lai, 55, and a dozen other real-estate agents camped out for 10 days along Toronto’s Bloor Street in late November for the chance to buy a home that won’t be completed for four years. "Where else is the world do you have agents lining up overnight to buy a condominium?" said Lai, with Tradeworld Realty Inc., a firm that has a sales staff of more than 200. He was bidding for a client on a condo costing as much as C$500,000. "We’re making history here," he said.
Venezuela Takes Greater Control of Banks
The government of President Hugo Chávez of Venezuela, facing a crisis at several banks acquired by his supporters, moved over the weekend to assert greater financial control by detaining one of the country’s most powerful financiers and forcing the resignation of the banker’s brother, who is a minister and a top Chávez aide.
The arrest on Saturday of the financier, Arné Chacón, and the removal of his brother, Jesse, as science minister, which Mr. Chávez announced Sunday, points to a broadening purge of a group of magnates known as Boligarchs, who built immense fortunes this decade on the back of close government ties. Their nickname is derived from the combination of Russian-style oligarchs and Simón Bolívar, the historical icon of Mr. Chávez’s political movement.
Besides Arné Chacón, Venezuelan authorities have detained several other bankers, including Ricardo Fernández Barrueco, a billionaire who went into finance after assembling a business empire that sold food to state-controlled supermarkets. All the bankers are believed to be under questioning by the Disip, Venezuela’s intelligence secret police. "We have been watching in awe at everything that has gone on over the past week, from the collapse and runs on the banks to the revolution eating its own," said Russell M. Dallen Jr., who oversees capital markets operations at BBO, a Caracas investment bank.
The crisis in the banking system began unfolding last Monday when the government seized control of four troubled banks, including those with ties to Mr. Fernández Barrueco, and then seized three other banks on Friday. Mr. Fernández Barrueco was arrested after he could not explain the origins of money used to buy the banks. Together, all the seized banks are estimated to account for less than 20 percent of the country’s banking system, dimming some fear that the crisis could infect other areas of Venezuela’s oil-based economy and easing concern of a Dubai-like debt crisis’s happening in Venezuela.
Still, Venezuelan markets were temporarily gripped by fear last week after Mr. Chávez threatened to nationalize the entire banking system if bankers did not obey the law. Capital flight fueled a plunge in the black-market value of the currency, the bolívar, and traders unloaded Venezuelan bonds before a reverse of panic selling on Friday.
Mr. Chávez, seeking to calm the population, said he was simply seeking to protect depositors. In his Sunday newspaper column, he reserved some vitriol for the arrested bankers, calling them "vulgar thieves, white-collar robbers, pickpockets." Mr. Chávez’s government still faces questions about the quick accumulation of fortunes by the arrested bankers, who drew deposits to their banks from deals with regional governments controlled by the president’s followers, leaving open the possibility that the purge could spread.
Bankers and economists in Venezuela also said it was not clear whether underlying financial problems at the banks had pushed the government to act. Depositors nervously lined up at some financial institutions in Venezuela last week in attempts to withdraw money, heightening concern over possible bank runs. The bankers embroiled in the scandal kept low profiles while expanding their empires. Arné Chacón, a former lowly army lieutenant, worked as a government tax official earlier this decade before quietly emerging as one of Venezuela’s top magnates, embarking on acquisition sprees that included banks, insurers and race horses.
Jesse Chacón, 44, also has a military background. He took part in Mr. Chávez’s unsuccessful 1992 coup attempt. Since Mr. Chávez’s rise to power 11 years ago, he has served as communications minister, justice minister and the president’s private secretary, before his most recent appointment as science minister. Mr. Fernández Barrueco, 44, forged ties with the government during a 2002 general strike by refusing to stop supplying food to grocery stores. Expanding into trucking and banking, his fortune reached $1.6 billion by 2005, according to an assessment by the Venezuelan affiliate of KPMG, the accounting firm.
The rise of these magnates had become a vulnerability for Mr. Chávez, who faced criticism from within his political movement over the seemingly unfettered operations of these decidedly capitalistic businessmen. For scholars of Venezuela’s economy, the emergence of such magnates has been a recurring feature of the country’s political evolution since oil became the dominant industry during the last century, with bureaucrats managing oil revenue and businessmen seeking lucrative government contracts.
This intermingling of state and private interests did not stop during Mr. Chávez’s government. Despite his efforts to assert greater state control over the economy, corruption in Venezuela is thriving by various measures. Transparency International, a Germany-based group that compiles a global corruption perception index, ranked Venezuela 162 out of 180 countries. "We’re now seeing a replay of this sudden-wealth mechanism, in which bureaucrats and businessmen become allies to capture oil revenues," said Pável Gómez, an economist at the Institute of Superior Administrative Studies, a Caracas business school. "Some of these players are now falling, but the system will allow other beneficiaries to emerge."
Costa Rica sees deflation in November
Consumer prices in Costa Rica fell by 0.16 percent during the month of November, marking the second time in 2009 that the country has experienced deflation. For the year, the inflation rate was at 2.57 percent, the lowest annual consumer price increase since 1972. At this point in time last year, the rate of inflation stood at 16.30 percent.
The largest decrease in consumer prices was felt at the gas pump, as the cost of gasoline fell more than 0.11 percent for the month. The price of gasoline is traditionally the driving force for fluctuation in the inflation rate, as the high inflation rate of 2008 stemmed largely from the high price of fuel. The overall cost of transportation has risen only 0.91 percent in 2009.
Average consumer prices also fell for car purchases, chicken, papayas and cable television. Increases in prices were seen in bus costs, sweet peppers, casados (a staple lunchtime dish featuring meat and rice and beans), home rentals and tourist packages. In September, the Central Bank of Costa Rica predicted the inflation rate for the year would reach between 4 and 6 percent. Barring a huge leap in consumer prices, those figures will not be met. The highest increase rate in 2009 was seen in July, when the consumer price index rose 0.92 percent.
Yemen teeters on brink of failure
The president's new mosque shimmers over this ancient city like an illusion of stability against images of MIG fighter jets screeching overhead toward rebellion in the north or the latest news of pirates seizing ships in the treacherous Gulf of Aden. In Sana's snug alleys, men speak of war, secession and Al Qaeda, which is busy scouring schoolyards and mosques for new recruits while much of the population spends hours each day getting a mellow buzz from chewing khat leaves.
If Yemen were a theater, which sometimes it appears to be, it would be an unnerving place of trapdoors and shifting facades. This is the poorest nation in the Arab world and one of the most strategically located, with 3 million barrels of oil sailing daily past its shores, tucked between Saudi Arabia and Somalia. And it is a teetering mess that some in Washington fear could draw the U.S. into a conflict with extremists at the intersection of the Middle East and the lawless Horn of Africa. "We are a failed state," said Abubakr A. Badeeb, a leading member of the opposition Socialist Party. "Yemen can no longer protect the rights of its citizens."
Others regard the country as a "failing" state, and the tricky thing about Yemen is parsing fact from fiction. Every scenario has a counter-narrative; every surface pulses with a beguiling underside. Is Al Qaeda a grave threat, or is its strength exaggerated by a government that needs U.S. attention and billions of dollars in aid from Persian Gulf nations? Is the war in the north a rebellion by a disaffected sect, or is it turning into a perilous proxy battle between Saudi Arabia and Iran, with the Saudis already launching military strikes across the border?
Yemeni President Ali Abdullah Saleh for almost 20 years has balanced conflicting tribal and sectarian voices, but his government's grip is slipping. Al Qaeda's aim is to exploit the economic crisis and domestic turmoil, overthrow the government and build a base for attacks across the region, Western and Yemeni intelligence officials say. Worried about terrorism and protecting oil supplies, the U.S. is working on a military cooperation pact with Yemen that includes training Yemeni special forces.
"Al Qaeda in the past focused on bombings and suicide attacks, but now it is also able to target security forces," said Saeed Ali O. Jemhi, an expert on terrorist groups in Yemen. "They have sympathizers and agents within the Yemeni security and intelligence forces. Al Qaeda is in a renewing stage, and its aim is to spread an Islamic caliphate across the Arabian Peninsula."
Washington's concern about Yemen has intensified since 2000, when militants slammed a motorboat packed with explosives into the U.S. destroyer Cole in the port of Aden, killing 17 sailors. The U.S. Embassy here in Sana, the capital, was attacked in 2008, leaving 19 dead, including a U.S. citizen. But non-military U.S. aid to Yemen has remained modest; this year totaling $24 million, up from $9.3 million the previous year. The Obama administration has requested about $65 million in counter-terrorism and military assistance.
It's a discomfiting task to choose Yemen's most pressing problem. Corruption is rampant, unemployment is 35%, child malnutrition is rising, water shortages are severe and oil reserves are shrinking. It says something about a country's priorities that most of its dwindling water supply goes to irrigating khat, whose bitter-tasting leaves have for generations kept Yemenis in a sedated haze. "Owing to the central government's historically weak control, the country has often been on the brink of chaos," said Christopher Boucek, an analyst with the Carnegie Center for International Peace. "Yemen has survived individual challenges in the past, but what differentiates the situation today is that multiple interconnected challenges are poised to converge at the same time."
The secessionist movement in the south threatens to split the country, but bombs and a surge of more than 175,000 people fleeing the war in the northwest is the consuming topic these days. There, Houthi rebels, Shiites of the Zaidi sect that had ruled for centuries, are battling Yemeni and Saudi forces along a border that stretches to the shipping lanes of the Red Sea.
The fighting, which began in August when the government launched Operation Scorched Earth, is the latest in a sporadic five-year insurgency. The Houthis say they are persecuted and marginalized, and they condemn Saleh, who is also a Zaidi, for being influenced by Sunni Wahhabi ideology from Saudi Arabia. The conflict, however, is rooted less in religion than in government failures and historical animosities in a mountainous region controlled by clans and tribes.
"The government hasn't offered jobs, education or development," said Mohammed Sabri, a political analyst. "The government thinks the war is a way to keep it in power. But they've chosen the wrong time and wrong place, and given the nation's circumstances, the war is spinning out of their control and they're trying to turn this businessmen's war into a proxy war." The Shiite and Sunni sectarian overtones have given the hostilities wider regional implications. The government says the Houthis are supported by Shiite-majority Iran. Tehran has denied the charges and the Yemeni regime has offered no credible evidence to back its assertions. Saudi Arabia joined the war in early November after cross-border raids by Houthis.
Riyadh fears two scenarios: The uprising will inspire unrest among the country's persecuted Shiite minority near its eastern oil fields, and that it will create a porous border for Al Qaeda militants to enter the kingdom to attack oil depots and government institutions. A Saudi militant based in Yemen slipped into the kingdom in August and blew himself up at a palace reception. Saudia Arabia's top counter-terrorism official, Muhammad bin Nayef, a member of the royal family, was injured. The attack reaffirmed to the kingdom, Yemen's biggest aid donor, that its southern neighbor was too strategically important to let it spiral into anarchy.
Politicians and clerics in Saudi Arabia and Iran have traded scathing rhetoric over Yemen, but so far the countries have avoided increasing military tensions. The kingdom is suspicious of Iran's ambitions, nuclear program and connections to the militant groups Hamas in the Gaza Strip and Hezbollah in Lebanon. Iranian Foreign Minister Manouchehr Mottaki recently issued a veiled warning over the Saudi intervention in Yemen, saying that "those who pour oil on the fire must know that they will not be spared from the smoke that billows." What's perhaps more troubling in the prospect of a failed Yemen is the effect it would have on the unstable Horn of Africa, where pirates roam and Al Qaeda cells hunker beneath U.S. predator drones.
Recent reports suggest that Houthi rebels may be training in camps in Somalia and that African refugees and mercenaries have joined Houthi ranks. This raises questions about the ability of Yemeni security forces to deal with multiple threats from sea and land. "With the modest navy we have we're trying, but we need international help. Piracy is a serious problem for everyone," said Mohammed Abulahoum, a member of the ruling General People's Congress party. "The U.S. needs a success story in the region. Yemen is important and Washington could have that success with a lower price tag than you would think."
The Saudi navy is patrolling the Red Sea to prevent arms and fighters from reaching the rebels. Iran has warships off the southern coast to protect shipping lanes, it says, from pirates. The confluence of so many competing and dangerous agendas, Yemen is small but too big to ignore. "Somalia and the Horn of Africa," Jemhi said, "are to Yemen what Afghanistan is to Pakistan."