"Widow & boy rolling papers for cigarettes in a dirty New York tenement"
Ilargi: While it's true that the Federal Reserve didn't say it in so many words, that's only because it's not capable of saying anything at all in only so many words. Perhaps that's due to Greenspan's Oracle heritage. Still, between the lines the Fed did say it: it has given up on an imminent recovery of the American economy, and most of all, it has given up on the American people. (Caveat: to give up on something one must at one time have cared for it to begin with.)
The Fed's recent and persistent rosy predictions of a 4% or so economic growth for the US have become ridiculously untenable, and Bernanke et al wish that to be known. That can only mean one thing: they see a lot more trouble on the horizon, and wish to cover their behinds and reputations. In true Oracle fashion, the wording itself has changed from "moderate" growth in June to "more modest than anticipated" yesterday. Here's thinking that Bernanke's definition of "exceptionally low rates for an extended period" doesn't apply only to interest rates, it's equally valid for economic growth.
For many pundits, the only conclusion that can be drawn from this is that the Fed will "ease" more, and is preparing to use its "vast range" of monetary tools to fight the depression everyone still prefers to call a recession. But, assuming for a moment that the Fed has any intention of doing so, what then are these tools? Note that even as the wording of the expectations has gone sharply downward, all the board has said is that it will replace some $20 billion per month in maturing agency and mortgage backed securities with Treasuries, so it will not hold less than $2.05 trillion in such paper.
Does that help the economy at large? No, of course not. And this is where you can see that the Fed has given up on the American people. Actions such as these help the banks, and the banks only. That is what the Fed has adopted as its first and singular priority: to keep the bankrupt banking system propped up, and to such an extent that banks not only look healthy, they even get to dole out gigantic sums in bonuses. The $2.05 trillion "bottom" announced yesterday is there to make sure that the banks won't suffocate from the toxic fumes their very own "assets" are spreading.
And it could perhaps work, or, more correctly, might have worked. If only sufficient economic growth would have enabled the continuation of the scheme. Alas, even the imitation Oracles can't go any further, or do any better, than "more modest than anticipated". That threatens to bring down the foundations of all western governments' financial strategies, and America's most of all. All the times that Tim Geithner has declared that there was no need for a plan B, because a plan of his couldn't fail, strong economic growth was an indispensable element in the plans. Bernanke has now admitted that such growth will not be available. Count your blessings.
All the talk around yesterday's Fed announcement focuses on quantitative easing, QE2. Which is somewhat bewildering, given the utter failure of QE1 in the US. The only thing QE1 achieved, again, was to prop up banks. Yes, that succeeded. But the goal was, or so we were led to believe, that the trillions the Fed injected would percolate through to the real economy.
That didn't happen. And no, that is no surprise to the Fed. Remember, if you will, that Bernanke sometime last year announced that the Fed would from there on in pay banks interest on their excess reserves (reserves they're not legally required to hold). These reserves, which banks hold with the Fed, have gone from $1-2 billion a few years ago to over $1 trillion today. And the Fed pays interest over them. If ever you wonder if maybe the Fed and the Treasury aren't looking out for your best interests after all, you may want to wonder why Bernanke doesn't simply announce that those interest payments will be gone by tomorrow morning. That could make the banks lend out the money, couldn't it?
Well, not so fast. There are other things that are wrong with the entire quantitative easing concept that hardly anyone cares to look at. The Pragmatic Capitalist has a great explanation:
Quantitative Easing: "The Greatest Monetary Non-Event"There is, perhaps, no greater misunderstanding in the investment world today than the topic of quantitative easing. After all, it sounds so fancy, strange and complex. But in reality, it is quite a simple operation. JJ Lando, a bond trader at Goldman Sachs, has eloquently described QE:“In QE, aside from its usual record keeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it needed to do all along. Again, they force people out of treasuries and into cash and reserves.”Some investors prefer to call it “money printing” or “stimulative monetary policy”. Both are misleading and the latter is particularly misleading in the current market environment. First of all, the Fed doesn’t actually “print” anything when it initiates its QE policy. The Fed simply electronically swaps an asset with the private sector. In most cases it swaps deposits with an interest bearing asset. They’re not “printing money” or dropping money from helicopters as many economists and pundits would have you believe. It is merely an asset swap.[..]
The most glaring example of failed QE is in Japan in 2001. Richard Koo refers to this event as the "greatest monetary non-event". In his book, The Holy Grail of Macroeconomics, Koo confirms what the BIS states above:"In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession. If there were many willing borrowers and few able lenders, the Bank of Japan, as the ultimate supplier of funds, would indeed have to do something. But when there are no borrowers the bank is powerless."[..]
No, no – Mr. Bernanke hasn’t failed. He just hasn’t tried hard enough….But perhaps the reader believes Japan is different and not applicable. This is a reasonable objection. So why don’t we look at the evidence from the last round of QE here in the USA. Since Ben Bernanke initiated his great monetarist gaffe in 2008 there has been almost no sign of a sustainable private sector recovery.
Mr. Bernanke’s new form of trickle down economics has surely fixed the banking sector (or at least bought some time), but the recovery ended there. It did not spread to Main Street. We would not even be having this discussion if we were in the midst of a private sector recovery. [..]
What is equally interesting (in addition to the fact that QE is not economically stimulative) with regards to this whole debate is that this policy response in time of a balance sheet recession is not actually inflationary at all. With the government merely swapping assets they are not actually "printing" any new money. In fact, the government is now essentially stealing interest bearing assets from the private sector and replacing them with deposits.
This might have made some sense when the credit markets were frozen and bank balance sheets were thought to be largely insolvent, but now that the banks are flush with excess reserves this policy response would in fact be deflationary- not inflationary. Why would we remove interest bearing assets from the private sector and replace them with deposits when history clearly shows that this will not stimulate borrowing?
Ilargi: So, there's no printing, and it's therefore not inflationary. Most of all, this is because nothing reaches the real economy. Bernanke's interest payments on excess reserves guarantee this outcome. What money banks do engage outside the Fed's vaults, they use for gambling on derivatives etc. Goldman made over a third of its profits last year from derivatives. And if these activities go awry, there's always the excess reserves to tap into. Get some at 0% (or close) at the discount window and get back to the gaming table. The 2010 US financial system in a nutshell.
Still, the key sentence above when it comes to the real economy is from Richard Koo: ... when there are no borrowers the bank is powerless .... This -crucial- statement appears again this morning in a piece from Rex Nutting at Marketwatch:
Monetary policy in a time of deleveragingWho cares what it costs to borrow when no one wants to take out a loan?[..]
The Fed has [..] flooded the economy with hundreds of billions of dollars. Instead of putting it to work, the banks have taken the Fed's money and parked it. [..]
... no one wants to borrow, and that's the biggest problem in getting the economy moving again.
The economy needs money to grow, and money is created by borrowing. No borrowing, no money growth. No money growth, no economic growth. No economic growth, no jobs.
Even 0% loans aren't attractive when you're deleveraging, when you're trying to work off the hangover that inevitably follows a binge of borrowing.
"And there isn't a damn thing Chairman Bernanke and company can do about it," says economist Stephen Stanley of Pierpont Securities.
Ilargi: Not a bad analysis, though of course it's simply not true that "The Fed has flooded the economy with hundreds of billions of dollars". . The Fed has flooded the banking system with all that money, but the banking system is not the same as the economy, even if the Geithners and Bernankes of this world would like you to think so, and are quite successful in convincing most people of this.
The take away from Nutting's piece is, even though we think we already know it, that money in our societies is created when people borrow it. It's then that a bank can create, for instance in the case of a mortgage, $250,000 with a keystroke. That's how we literally "make money". The Fed can do what it will, but if you're not going out there to get that loan, no money is created that actually enters the economy. No matter how many trillions the Fed hands over to Wall Street, it won’t go anywhere until you apply for a loan. Which, in today's circumstances, will then mostly be denied. Isn't the irony spectacularly appealing?
Craig Torres and Vivien Lou Chen at Bloomberg have a few more observations from the same Stephen Stanley Rex Nutting quotes in the article above, as well as a bit more on Bernanke's Oracle style:
Fed Reverses Exit Plans, Sets $2 Trillion Floor for Holdings"There is absolutely zero evidence that if you let the balance sheet run down $10 billion to $15 billion a month that it would be a binding restraint on the economy," said Stephen Stanley, chief economist at Pierpont Securities [..]
"They have given us no evidence why quantitative easing works," Stanley said.
Some observers said yesterday’s decision took them by surprise after Bernanke and other officials in recent weeks maintained their outlook for a pickup in the economy over the next year. While weakness in housing and commercial real estate will restrain the recovery, and the job market’s "slow recovery" weighs on consumers, "rising demand from households and businesses should help sustain growth," Bernanke said in an Aug. 2 speech in Charleston, South Carolina.
"It seems like communications is a problem, particularly around turning points," said Timothy Duy, a University of Oregon economist who formerly worked at the U.S. Treasury Department. "It seems odd that 10 days ago you had a speech that hardly acknowledged the weakness of the recent data."
Ilargi: I think it should be obvious by now that that is exactly the kind of light in which to read yesterday's Fed announcement. Odd. But at the same time, it was quite the turnaround from all that's been said before, and right there lies the important bit. They've given up on the recovery, and to a much greater extent than they let on. Got to feed it to the people bite-size, that's politics for you. Makes you wonder how Obama and Geithner will spin it.
Don't forget that one of the policy requirements for the Federal Reserve is "maximum employment". And then look at what they're doing to achieve it. How will the president tell his people that no economic growth means no jobs?
One last thing: a huge chunk of the mortgage backed securities the Fed holds (some $1,25 trillion of them) originated with Fannie Mae and Freddie Mac. A "trick" very similar to the one that lets banks hold excess reserves at the Fed and get paid to do so, plays in the Fannie and Freddie universe. Where the Fed supposedly tries to support the economy through QE, but makes sure it can never work when it starts paying interest on reserves, the government makes sure the housing industry will not get back on its feet, simply by guaranteeing every single mortgage that's closed at inflated prices. Both "tricks" pretend to help the people, but both in the end only help to support a broke banking system. And it's impossible to keep up the illusion that none of these smart people have figured that one out.
Fannie Mae belongs to the government. Fannie Mae also has started advertising $1000 down mortgage loans in select parts of the US. Granted, it's a last stage of desperation move, but the fact that it's even considered is what tells us the story of how our "leaders" see the world around them. On the one hand, you’d be inclined to think that it's a good thing the phony facade is about to fall, but on the other you quickly realize who will be the victims once that happens.
And then you need to ask: what are those mortgage backed securities the Fed holds really worth, and who will eventually make up for the difference between face value and actual worth?
Look, mortgage rates are at record lows. And so are pending home sales. Combine those two, and you have all you need to know about the future of the American economy. It really is that simple.
If no-one's borrowing, the overall money supply goes down. That spells deflation, and the Fed is powerless against it. It can't force you to borrow. And if no economic growth materializes, you're not going to increase borrowing. Because you'll be losing your jobs, or famliy, friends, neighbors will, and you’ll be forewarned.
And they know it too, Bernanke and Geithner. The Fed doesn't support you, the American people, it supports the zombie banking system at your cost. Seen from that particular angle, by the way, it's doing a great job. I’ll leave it up to you to decide where the Treasury, and the US government in general, stand on this. Think Fannie and Freddie.
Fed Reverses Exit Plans, Sets $2 Trillion Floor for Holdings
by Craig Torres and Vivien Lou Chen - Bloomberg
The Federal Reserve reversed plans to exit from aggressive monetary stimulus and decided to keep its bond holdings level to support an economic recovery it described as weaker than anticipated. Central bankers meeting yesterday adopted a $2.05 trillion floor for their securities portfolio, pivoting toward a quantitative target for monetary policy. Treasuries surged and stocks pared losses as some investors judged the decision opened the door to a resumption of large-scale asset purchases.
"The Fed is cognizant the recovery has lost some momentum and it is still willing to intervene," said Paul Ballew, a former Fed economist and a senior vice president at Nationwide Mutual Insurance Co. in Columbus, Ohio. "We always thought the exit strategy would be challenging. If you’re at the Fed, it’s proven to be more problematic than what you thought."
Officials directed the New York Fed’s trading desk to reinvest what economists estimate will be $15 billion to $20 billion a month in maturing agency and mortgage-backed securities back into U.S. Treasuries. The purchases will help keep Treasury yields and mortgage costs low and prevent the level of monetary stimulus from shrinking further. "They are now targeting a balance-sheet level, and the fact they are targeting the balance sheet is new," said Julia Coronado, a senior U.S. economist at BNP Paribas in New York who worked on the Fed Board staff for seven years. Any further easing "will likely come in the form of a higher balance sheet and investment in Treasuries."
The dollar rose 0.8 percent against the euro today, climbing to $1.3071 at 9:56 a.m. in London. Stocks fell, with the Stoxx Europe 600 Index dropping 0.9 percent and the MSCI Asia Pacific Index losing 1.6 percent. Standard & Poor 500’s index futures decreased 0.9 percent. Yields on U.S. 10-year notes yesterday dropped to an 18- month low and closed at 2.76 percent in late New York trading, down 7 basis points. A basis point is 0.01 percentage point.
U.S. central bankers came to their August meeting with a series of reports that pointed to slowing growth. U.S. companies added 71,000 workers to private payrolls in July, less than forecast by economists, and June gains were revised down to 31,000. The unemployment rate stayed at 9.5 percent. The jobless rate has sapped confidence, reducing consumer spending to a 1.6 percent annual rate in the second quarter, about half the average pace in the last expansion. U.S. companies don’t have much room to raise prices in the face of weak demand, keeping inflation low.
The Fed’s decision yesterday may not succeed in bringing down unemployment even as it supports "risk assets," said Anthony Crescenzi at Pacific Investment Management Co., manager of the world’s biggest bond fund. Those jobs "won’t be recovered easily, certainly not by adding a couple hundred billion dollars into the banking system," Crescenzi said in an interview on Bloomberg Television. At the same time, "low volatility tends to be good for the interest-rate climate. It does push investors out the risk spectrum generally. That tends to be good for risk assets."
Aeropostale Inc., a retailer to teenagers whose sales rose in July at one-seventh the pace analysts predicted, said changing consumer preferences and a "challenging" retail environment hampered spending. Sales at J.C. Penney Co., a department-store chain, fell 0.6 percent last month.
"The pace of recovery in output and employment has slowed in recent months," the Federal Open Market Committee said in its statement yesterday. "Measures of underlying inflation have trended lower in recent quarters." The personal consumption expenditures price index, minus food and energy, rose at a 1.4 percent rate for the 12 months ending June, below the 1.7 percent to 2 percent annual rate Fed officials view as preferable, according to their June forecasts.
The Fed left the overnight interbank lending rate target in a range of zero to 0.25 percent, where it’s been since December 2008, and repeated a pledge to keep rates low "for an extended period." The risk faced by the Fed is that growth slows to a pace that leaves unemployment high "as far as the eye can see," said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York. That could increase the risk of deflation, or a general decline in prices that saps consumer spending and corporate profits and increases the value of debt.
"It is possible that they are just getting more worried about whether we are getting a rebound and a strong cyclical lift," Feroli said. Feroli and other economists said they were puzzled by the Fed’s choice of a $2 trillion target for its portfolio and said the central bank hasn’t explained how such a goal would "help support the economic recovery," as its statement said.
"There is absolutely zero evidence that if you let the balance sheet run down $10 billion to $15 billion a month that it would be a binding restraint on the economy," said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. Until now, Fed Chairman Ben S. Bernanke has deployed what he called "credit easing," using backstops such as the Commercial Paper Funding Facility and purchases of $1.25 trillion in mortgage-backed securities to lean against higher credit costs for home buyers and U.S. corporations as investors shunned risk.
Balance Sheet Swells
The Fed’s total assets, which include loans and securities other than those used for monetary-policy operations, rose to $2.33 trillion last week from $878 billion at the start of 2007. Even so, Fed officials never had a formal target for the balance sheet level. "They have given us no evidence why quantitative easing works," Stanley said. Some observers said yesterday’s decision took them by surprise after Bernanke and other officials in recent weeks maintained their outlook for a pickup in the economy over the next year.
While weakness in housing and commercial real estate will restrain the recovery, and the job market’s "slow recovery" weighs on consumers, "rising demand from households and businesses should help sustain growth," Bernanke said in an Aug. 2 speech in Charleston, South Carolina. "It seems like communications is a problem, particularly around turning points," said Timothy Duy, a University of Oregon economist who formerly worked at the U.S. Treasury Department. "It seems odd that 10 days ago you had a speech that hardly acknowledged the weakness of the recent data."
Monetary policy in a time of deleveraging
by Rex Nutting - MarketWatch
The Fed can't do much more to get credit flowing
The U.S. economy is on the edge of the cliff, threatening to plunge back into ruinous recession, but the worst part is that Washington won't do anything to stop it. The shame is that the Federal Reserve, the White House and Congress know they have a duty to act decisively, but they can't or won't under the mistaken notion that they've already done too much. We were sicker than they thought, but instead of increasing the dosage or looking for a better medicine, they've declared us to be cured.
Well, not cured, exactly, but as healthy as we're going to get. We'll just have to live with the nagging cough, the constant pain and the bleeding gums. Honestly, once you get used to it, you'll barely even notice 8% unemployment and falling living standards. To its credit, the Federal Reserve is at least keeping open the option of further stimulus to nudge the economy back to life. On Tuesday, the Fed said it would reinvest the proceeds of the maturing mortgage-backed bonds that it owns, thus preventing a stealth tightening of policy as the bonds run off.
For their part, the politicians in the White House and Congress have simply given up on any significant additional impetus for the economy. The Fed is also reluctant to act, in part because officials are worried that monetary policy has run up against the boundary of what it can accomplish.
The essence of monetary policy is to influence the cost of borrowing by raising or lowering the interest rate that banks pay to borrow money from each other overnight, which is called the federal funds rate. The Fed can affect the money supply by manipulating this rate. Lower rates mean easier credit, which, in normal times, leads to economic growth and job creation as businesses and consumers borrow. But no one has to tell us that these are not normal times. Who cares what it costs to borrow when no one wants to take out a loan?
The Fed has lowered the federal funds rate essentially to zero, and it's flooded the economy with hundreds of billions of dollars. Instead of putting it to work, the banks have taken the Fed's money and parked it. The banks are nervous about lending it out, remembering what happened the last time. What's more, no one wants to borrow, and that's the biggest problem in getting the economy moving again. The economy needs money to grow, and money is created by borrowing. No borrowing, no money growth. No money growth, no economic growth. No economic growth, no jobs.
Instead, small businesses and consumers are busy paying down debt. Even 0% loans aren't attractive when you're deleveraging, when you're trying to work off the hangover that inevitably follows a binge of borrowing. "And there isn't a damn thing Chairman Bernanke and company can do about it," says economist Stephen Stanley of Pierpont Securities. The Fed is "pushing on a string," to quote one of the favorite metaphors of economists.
Easing not easy
The Fed has tried some fancy stuff to get around the problem of trying to get reluctant people to lend and borrow. It's tried quantitative easing, where the Fed goes into the market and buys securities such as Treasurys or mortgage-backed bonds. In exchange, the former owners of those securities now have cash burning a hole in their pockets. What to do with the proceeds? Splurge on consumer goods and stimulate the economy? Invest in some risky but potentially lucrative new venture that will create new jobs and economic growth? Or put it into a boring S&P 500 stock fund and buy more Treasurys? Guess what happened.
It's pretty clear that quantitative easing isn't a very efficient way to stimulate the economy. The Fed may try it again, but we shouldn't be surprised if it's ineffective. The Fed could just wait for households and small businesses to pare down their debts. Someday, they'll be ready, willing and able to borrow again. This is the point in the argument when John Maynard Keynes reminded us that, "in the long run, we are all dead."
The output gap -- the difference between where we are and where we should be -- isn't just lines on paper or theories in a classroom; it's real incomes that aren't earned, real goods and services that aren't produced or consumed, real dreams that aren't realized. It doesn't take a poet to know what happens to a dream deferred. Sometimes, it explodes. If the Fed's hands are tied, are we doomed to a lost decade of deferred dreams?
Happily, no. There is one group that's still able to borrow: the federal government, which could fill the gap temporarily by directly employing idle people to fulfill some of those deferred dreams. They could teach the children, heal the sick, build the infrastructure, discover new drugs, and invent new technologies. Unhappily, it's not going to happen.
Fed Shuns Passive Tightening, No QE2 in Sight
by Caroline Baum - Bloomberg
Downgrading its assessment of the pace of the economic recovery from "moderate" in June to "more modest than anticipated," the Federal Reserve took a symbolic step toward additional easing of monetary policy. The Fed will "keep constant" its securities portfolio, reinvesting the principal payments from agency and mortgage- backed securities in long-term Treasuries, according to the statement released following yesterday’s meeting.
The New York Fed, which conducts open market operations for the system, put out a qualifying statement saying its Treasury purchases would be concentrated in the two- to 10-year sector. Much of the economic commentary coming over the transom following yesterday’s meeting suggested the Fed had embarked on a second round of quantitative easing, familiarly known as QE2. How can it be quantitative easing when the quantity remains the same? What the Fed committed to, for the moment, is to maintain the size of its securities portfolio at $2.05 trillion rather than engage in passive tightening by allowing the balance sheet to shrink due to principal payments and maturing debt.
The Fed had been letting its mortgage portfolio shrink ever-so-slightly in recent months, even though the balance sheet has been stable since mid-April. Now the Fed will buy some $100 billion to $200 billion of Treasuries a year to offset the shrinkage, according to Neal Soss, chief economist at Credit Suisse in New York. That estimate is based on the normal pre-payment and amortization schedule on a similar-size mortgage portfolio.
I have no idea whether the Fed will decide, next month or next year, to expand the size of its $2.3 trillion balance sheet. There was nothing in today’s statement to indicate what lies ahead. The Fed’s current assessment of the economy (not so hot) is backward-looking, based on the most recent economic data and just as reliable. The data were weak enough to "shake their confidence in the forecast," Soss says.
Earlier this year, the exit strategy was all the rage. Policy makers were focused on how to unwind the Fed’s bloated balance sheet without causing dislocations in the housing market and the economy at large. That noise you hear is the sound of the exit door being slammed shut. Yesterday, the Fed put us on notice that it’s getting out the WD-40 and oiling the hinges on the entry door. The decision to substitute Treasuries for maturing MBS will be welcome news to those Fed officials who want the central bank to get out of the credit business and return to a "Treasuries only" policy.
Credit policy pertains to what the Fed buys. Quantitative easing tells us how much. QE1 led to an explosion in excess reserves, the reserves banks choose to hold over and above what they’re required to. They rose to $1 trillion from a pre-crisis range of $1 billion to $2 billion. If the Fed wants to put some oomph into QE2, it’s going to have to get the reserves out of the banks and into the economy. One way would be to raise the cost of not lending. Banks now earn 0.25 basis points on their reserves. (It wasn’t so long ago that paying interest on excess reserves was seen as a way to prevent an inflationary expansion of credit.) Reducing or eliminating the interest on reserves would, at the margin, entice banks to buy securities or make loans, expanding the money supply.
That was one of two other options -- aside from the one chosen yesterday -- that Fed chief Ben Bernanke laid out at his semi-annual monetary policy testimony last month. The second was tinkering with the assurances of "exceptionally low" rates for an "extended period." How the Fed can guarantee a more extended "extended period," both verbally and practically, when its outlook changes from one meeting to the next, is beyond me. Then again, I’m still trying to figure out where the Q is in QE2.
Quantitative Easing: "The Greatest Monetary Non-Event"
by The Pragmatic Capitalist
The topic of quantitative easing (QE) has rapidly become the most important discussion in the investment world. As deflation becomes the obvious risk and the economic recovery looks increasingly weak investors are again looking to the Fed to save their skin from a Japan style deflationary recession. The irony here is so thick you could choke on it, however, like some sort of sick masochist, investors continue to return to the trough of the Federal Reserve so they can gorge on half-truths and misguided policy responses.
There is perhaps, no greater misunderstanding in the investment world today than the topic of quantitative easing. After all, it sounds so fancy, strange and complex. But in reality, it is quite a simple operation. JJ Lando a bond trader at Goldman Sachs has eloquently described QE:“In QE, aside from its usual record keeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it needed to do all along. Again, they force people out of treasuries and into cash and reserves.”
Some investors prefer to call it “money printing” or “stimulative monetary policy”. Both are misleading and the latter is particularly misleading in the current market environment. First of all, the Fed doesn’t actually “print” anything when it initiates its QE policy. The Fed simply electronically swaps an asset with the private sector. In most cases it swaps deposits with an interest bearing asset. They’re not “printing money” or dropping money from helicopters as many economists and pundits would have you believe. It is merely an asset swap.
The theory behind QE is that the Fed can reduce interest rates via asset purchases (which supposedly creates demand for debt) while also strengthening the bank balance sheet (which entices them to lend). Unfortunately, we’ve lived thru this scenario before and history shows us that neither is actually true. Banks are never reserve constrained and a private sector that is deeply indebted will not likely be enticed to borrow regardless of the rate of interest. On the reserve argument the BIS explains in great detail why an increase in reserves will not increase borrowing:“In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.
The aggregate availability of bank reserves does not constrain the expansion directly. The reason is simple: as explained in Section I, under scheme 1 – by far the most common – in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost of intermediation and that of loans, but does not constrain credit expansion quantitatively.
The main exogenous constraint on the expansion of credit is minimum capital requirements. By the same token, under scheme 2, an expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best. This is true in both normal and also in stress conditions. Importantly, excess reserves do not represent idle resources nor should they be viewed as somehow undesired by banks (again, recall that our notion of excess refers to holdings above minimum requirements). When the opportunity cost of excess reserves is zero, either because they are remunerated at the policy rate or the latter reaches the zero lower bound, they simply represent a form of liquid asset for banks.”
The most glaring example of failed QE is in Japan in 2001. Richard Koo refers to this event as the “greatest monetary non-event”. In his book, The Holy Grail of Macroeconomics, Koo confirms what the BIS states above:“In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession. If there were many willing borrowers and few able lenders, the Bank of Japan, as the ultimate supplier of funds, would indeed have to do something. But when there are no borrowers the bank is powerless.”
In the same piece cited above, the BIS also uses the example of Japan to illustrate the weakness of QE. The following chart (Figure 1) shows that QE does not stimulate borrowing (and the history of continued economic weakness in Japan is coincidental):“A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s "quantitative easing" policy in 2001-2006. Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly.”
Koo goes a step further in describing the failure of QE to promote private sector recovery. His simple example is one I have used often:“The central bank’s implementation of QE at a time of zero interest rates was similar to a shopkeeper who, unable to sell more than 100 apples a day at $100 each, tries stocking the shelves with 1,000 apples, and when that has no effect, adds another 1,000. As long as the price remains the same, there is no reason consumer behavior should change–sales will remain stuck at about 100 even if the shopkeeper puts 3,000 apples on display. This is essentially the story of QE, which not only failed to bring about economic recovery, but also failed to stop asset prices from falling well into 2003.”
Koo continues by emphasizing how ineffective monetary policy is during a balance sheet recession:“Even though QE failed to produce the expected results, the belief that monetary policy is always effective persists among economists in Japan and elsewhere. To these economists, QE did not fail: it simply was not tried hard enough. According to this view, if boosting excess reserves of commercial banks to $25 trillion has no effect, then we should try injecting $50 trillion, or $100 trillion”
After years of placing more apples on the shelves the Bank of Japan finally admitted that the policy had been a failure:“QE’s effect on raising aggregate demand and prices was often limited” (Ugai, 2006)
That all sounds too eerily familiar, doesn’t it? No, no – Mr. Bernanke hasn’t failed. He just hasn’t tried hard enough….But perhaps the reader believes Japan is different and not applicable. This is a reasonable objection. So why don’t we look at the evidence from the last round of QE here in the USA. Since Ben Bernanke initiated his great monetarist gaffe in 2008 there has been almost no sign of a sustainable private sector recovery. Mr. Bernanke’s new form of trickle down economics has surely fixed the banking sector (or at least bought some time), but the recovery ended there. It did not spread to Main Street. We would not even be having this discussion if we were in the midst of a private sector recovery. The surest evidence, however, is in the Fed’s own data. We can also look at the Fed’s recent Z1 to show that households remain hesitant to borrow (see Figure 2). Friday’s consumer credit data was yet another sign of contracting consumer credit and a lack of demand for borrowing. Despite the Fed’s already failed attempt at QE (see Figure 3) we are convinced that Mr. Bernanke just needs to throw a few more apples on the shelves. The historical evidence is clear – QE will do little to stimulate borrowing and help generate a private sector recovery.
In addition, there is one great irony in all of this misunderstanding. The hyperventilating hyperinflationists and those investors calling for inevitable US default are now clinging to this QE story as their inflation or default thesis crumbles before their very eyes. The new hyperinflationist theme has become a story of “if this, then this, then THIS!” – the ludicrous 3 step investment thesis that the economy will become so fragile that the government will pile on with more stimulus, which will worsen matters and force them to stimulate further which will then result in hyperinflation and/or default. Most investors have enough trouble predicting what the next event will be – connecting the dots two or three steps down the line is not only ill-advised, but is hardly even worthy of consideration….Let’s just call a spade a spade – the inflationistas have been wrong and the USA defaultistas have been horribly wrong.
What is equally interesting (in addition to the fact that QE is not economically stimulative) with regards to this whole debate is that this policy response in time of a balance sheet recession is not actually inflationary at all. With the government merely swapping assets they are not actually “printing” any new money. In fact, the government is now essentially stealing interest bearing assets from the private sector and replacing them with deposits. This might have made some sense when the credit markets were frozen and bank balance sheets were thought to be largely insolvent, but now that the banks are flush with excess reserves this policy response would in fact be deflationary - not inflationary. Why would we remove interest bearing assets from the private sector and replace them with deposits when history clearly shows that this will not stimulate borrowing?
All of this misconception has the market in a frenzy. Portfolio managers and day traders can’t wait to snatch up stocks on every dip in anticipation of what they believe is an equivalent to the March 9th 2009 low that was cemented by government intervention. As I have long predicted Ben & Co. have failed. If there is one thing that we know for certain over the last 24 months it is that Mr. Bernanke’s monetary policy has done very little to get the private sector back on its feet. This man failed to predict the crisis (was in fact oblivious to its potential), initiated the wrong trickle down policy response and yet now we turn to him to save us from a double dip and his Committee responds with more discussion of QE? Will we ever learn?
In describing the negligence of such monetary policy Richard Koo uses the analogy of a doctor who simply tells his patient to take more of the same medicine he originally prescribed:“At the risk of belabouring the obvious, imagine a patient in the hospital who takes a drug prescribed by her doctor, but does not react as the doctor expected and, more importantly, does not get better. When she reports back to the doctor, he tells her to double the dosage. But this does not help either. So he orders her to take four times, eight times, and finally a hundred times the original dosage. All to no avail. Under these circumstances, any normal human being would come to the conclusion that the doctor’s original diagnosis was wrong, and that the patient suffered from a different disease. But today’s macroeconomics assumes that private sector firms are maximizing profits at all times, meaning that given a low enough interest rate, they should be willing to borrow money to invest.. In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession.”
Dr. Bernanke has misdiagnosed this illness one too many times. At what point does someone tell him to put the scalpel down and step away from the table before he does even greater harm?
Commodity spike queers the pitch for Bernanke's QE2
by Ambrose Evans-Pritchard - Telegraph
Don't be fooled: a food and oil price spike is not and cannot be inflationary in those advanced industrial economies where the credit system remains broken, the broad money supply is contracting, and fiscal policy is tightening by design or default.
It is deflationary, acting as a transfer tax to petro-powers and the agro-bloc. It saps demand from the rest of the economy. If recovery is already losing steam in the US, Japan, Italy, and France as the OECD's leading indicators suggest - or stalling altogether as some fear - the Eurasian wheat crisis will merely give them an extra shove over the edge. Agflation may indeed be a headache for China and India, where economies have over-heated and food is a big part of the inflation index. But the West is another story.
Yields on two-year US Treasury debt fell last week to 0.50pc, the lowest in history. Core US inflation is the lowest since the mid-1960s. US business inflation (pricing power) is at zero. Bank lending is flat and securitised consumer credit has collapsed from $900bn to $240bn in the last year. Hence the latest shock thriller - "Seven Faces of Peril" by James Bullard, ex-hawk from the St Louis Fed - who fears US is now just one accident away from a Japanese liquidity trap.
In Japan itself core CPI deflation has reached -1.5pc, the lowest since the great fiasco began 20 years ago. 10-year yields fell briefly below 1pc last week. Premier Naoto Kan has begun to talk of yet another stimulus package. "The time has come to examine whether it is necessary for us take some kind of action," he said. In a normal recovery, the US labour market would be firing on all cylinders at this stage. Yet the latest household jobs survey showed a net loss of 35,000 jobs in May, 301,000 in June, 159,000 in July.
The ratio of the working age population with jobs has fallen to 58.4, back where it was in the depths of recession. Over 1.2m people have dropped out the work force over the last three months, which is the only reason why the unemployment rate has not vaulted back into double digits. A record 41m Americans are on food stamps. This is unlike anything since the Second World War. It screams Japan, our L-shaped destiny. "Unprecedented monetary and fiscal stimulus has produced unprecedentedly weak recovery", said Albert Edwards from Societe Generale in his latest "Ice Age" missive. That stimulus is now fading fast before the private economy has clasped the baton.
After digesting Friday's jobs report, Goldman Sachs' chief economist, Jan Hatzius, thinks the Fed will abandon its exit strategy and relaunch QE this week, taking the first "baby step" of rolling over mortgage securities. Future asset purchases may be "at least $1 trillion". He is not alone. Every bank seems to be gearing up for QE2, even the inflation bulls at Barclays. The unthinkable is becoming consensus.
Into this deflationary maelstrom, we now have the extra curve ball of Russia's export ban on grains. There is a risk that this mini-crisis will escalate if Kazakhstan, Belarus, and Ukraine follow suit, and if the scorching drought lasts long enough to hit seeding for winter wheat next month. But remember, there was a global wheat glut until six weeks ago. Stocks are at a 23-year high. Prices are barely more than half the peak in 2008. The US grain harvest is bountiful; Australia, India, Argentina look healthy.
The Reuters CRB commodity index is no higher now than in April. Last week's commodity scare looks like an anaemic version of the blow-off seen in the summer of 2008. The chief risk is that central banks will panic yet again, seeing ghosts of a 1970s wage-price spiral that does not exist. In July 2008, Jean-Claude Trichet told Die Zeit that there was "a risk of inflation exploding". As we now know - and many predicted - eurozone inflation was about to fall off a cliff. But acting on this apercu, the European Central Bank raised rates. No matter that half Europe was already tipping into recession.
The Western banking system went into melt-down within weeks. The Fed was not much better. It issued an "inflation alarm" in August 2008. Dr Robert Hetzel of the Richmond Fed has written a candid post-mortem in "Monetary Policy In The 2008-2009 Recession", rebuking the Fed and ECB for over-reacting to inflacionista hysteria. They tightened into the crunch. For those wonkishly inclined, Dr Hetzel said their error was to view the enveloping crisis through a "credit" prism, missing the tectonic issue that the "natural rate of interest" had fallen below the Fed funds rate. Failure to diagnose the problem properly meant that Fed policy may have made matters worse. This is perhaps the best analysis I have ever read on what went wrong, yet it has received scant attention.
Do we have any assurance that central banks have learnt their lesson? Clearly not the ECB, judging from Mr Trichet's ill-judged article for the Financial Times two weeks ago: "Now it is Time for all to Tighten". Much of what he wrote is correct in as far as it goes. Public debt is out of control. Budget stimulus may start to backfire. We are at risk of a "non-linear" rupture should confidence suddenly snap in sovereign states. Yet he also suggested that half the world can copy the fiscal purges of Canada and Scandinavia in the 1990s, all at the same time, without setting off a collective downward spiral. He offered no glimmer of recognition that the fiscal squeeze must be offset by ultra-loose money. True to form, the ECB is now draining liquidity. Three-month Euribor has risen to the highest in over a year.
John Makin from the American Enterprise Institute described the Trichet argument that collective removal of fiscal thrust can be expansionary as "preposterous and dangerous". Mr Edwards called it "risible". Berkeley's arch-Keynesian Brad DeLong could only weep, saddened that everything learned over 70 years had been tossed aside in a total victory for 1931 liquidationism. "How did we lose the argument," he asked?
Unfortunately, such obscurantism is taking hold in the US as well. Alabama Senator Richard Shelby has blocked the appointment of MIT professor Peter Diamond to the Fed Board, ostensibly because he is a labour expert rather than a monetary economist but in reality because he is a dove in the ever-more bitter and polarised dispute over QE. The Senate has delayed confirmation of all three appointees for the board, who all happen to be doves and allies of Fed chairman Ben Bernanke. The Fed is in limbo until mid-September. So the regional hawks who so much misjudged matters in 2008 have unusual voting weight, and now they have a commodity spike as well to rationalise their Calvinist preferences.
Whatever Dr Bernanke wants to do this week - and I suspect he is eyeing the $5 trillion button lovingly - he cannot risk dissent from three Fed chiefs: one yes, two maybe, but not three. He faces a populist revolt from the Tea Party movement, with its adherents in Congress and the commentariat. And China simply hates QE, which may or may not be rational but cannot be ignored. Global markets have already priced in the next QE bail-out, banking the "Bernanke Put" as if it were a done deal. We will find out on Tuesday if life is really that simple.
Time to Re-think Milton Friedman?
by Rick Ackerman
Adding fuel to our recent discussion of deflation is the latest dispatch from Ambrose Evans-Pritchard, the only big-league journalist we know of who seems to have recognized all along that it is not inflation we should have feared, but deflation. "Don’t be fooled," he wrote recently in the U.K. Telegraph. "A food and oil price spike is not and cannot be inflationary in those advanced industrial economies where the credit system remains broken, the broad money supply is contracting, and fiscal policy is tightening by design or default."
Just so. And yet, there are still those who choose not to see the obvious. We still turn up posts in the Rick’s Picks forum that would have us believe that supposed price increases in day-to-day necessities represent a significant offset to a global financial implosion that has sucked hundreds of trillions of dollars worth of valuation from a global portfolio of leveraged financial assets.
This is hugely deflationary, as Evans-Pritchard notes, and in the case of higher grocery and energy costs, acts "as a transfer tax to petro-powers and the agro-bloc. It saps demand from the rest of the economy. If recovery is already losing steam in the US, Japan, Italy, and France as the OECD's leading indicators suggest -- or stalling altogether as some fear -- the Eurasian wheat crisis will merely give them an extra shove over the edge." This touches on a point we’ve made here before, and more than a few times – that price increases in necessities cannot create inflation if household incomes are stagnant.
Think about it: If the price of a gallon of gas were to rise to $10 a gallon tomorrow, we would simply have to cut back on the consumption of something less important. So where’s the inflation? Why the answer to this question continues to elude so many is mystifying. Perhaps those who remain skeptical of deflation’s power are renters who have not experienced the pain of having their mortgaged home decrease in value by 30 percent or more, as has occurred throughout the US.
Most persistent of the inflationists’ delusions is that the Federal Reserve can and will do "whatever it takes" to avoid deflation. But to believe that easing has not worked so far because the Fed has not eased enough is to imply that some further quantity of easing will do the trick. This kind of thinking is beyond dumb, but when it infects those on the left side of the Congressional aisle, it can be downright dangerous. Tea Partiers to the rescue?
They supposedly stand ready to put a lid on yet another round of stimulus, but at this point, probably, most Americans recognize that more stimulus, all of it with money to be borrowed by "the government" (i.e., by taxpayers) from future productivity, cannot achieve much of anything, save burying us even deeper in debt.
It manifestly has not stimulated inflation, as Evans-Pritchard notes with this short list of current data: "Yields on two-year US Treasury debt fell last week to 0.50 percent, the lowest in history. Core US inflation is the lowest since the mid-1960s. US business inflation (pricing power) is at zero. Bank lending is flat and securitised consumer credit has collapsed from $900 billion to $240 billion in the last year. Hence the latest shock thriller -- "Seven Faces of Peril" by James Bullard, ex-hawk from the St Louis Fed -- who fears that the United States is now just one accident away from a Japanese liquidity trap."
Readers, what do you think? We would be especially grateful to anyone who can drive a stake through the heart of the oft-repeated phrase "inflation is always and everywhere a monetary phenomenon." This phrase, demonstrated to have been worse than worthless for predictive purposes by actual monetary events of the last two decades, originated with economist Milton Friedman but has since been expropriated by armchair theoreticians, monetarists and others who have been more or less continuously –and wrongly -- predicting a horrific outbreak of CPI inflation since around 1991.
That is when the Fed eased massively (or so it seemed, for those times) to power us out of recession and the S&L crisis. Friedman, like virtually all of the monetarists his theories had empowered, might have been fooled the first time around, when the universally predicted inflationary spiral failed to materialize thereafter. But we wonder what he would think now, had he been able to witness how the cosmic-size stimulus of the last few years failed to produce any inflation whatsoever.
Indeed, recent events have demonstrated that all of the credit-money the Fed is capable of ginning up will not produce even an iota of inflation if borrowers and lenders do not take that money and run with it. Some might say the easing associated with the 1990-91 recession did in fact produce inflation, albeit of equity shares rather than consumer goods.
They would also note that subsequent periods of loose money caused massive inflation of financial assets and real estate. This line of argument is disingenuous, however, since, even as these inflationary events were unfolding, low CPI inflation was explicitly cited by policymakers as justification for further easing. Moreover, Alan Greenspan, to the eternal disgrace of an already Dismal Science, regarded all non-CPI inflation not only as benign but, in the case of home prices, as wealth-producing.
We doubt that Friedman would have made so egregious a mistake. Dare we imagine that if he were still alive, that, seeing the catastrophe that Fed manipulation of interest rates had wrought, he’d be more willing to let market forces alone, rather than the central bank, determine when the supply and demand for money were in equilibrium?
Fed Will Meet With Concerns on Deflation Rising
by Sewell Chan - New York Times
The Federal Reserve will meet on Tuesday faced with a pivotal decision about whether to abandon its presumption that the economy is gradually picking up steam and begin to consider new steps to keep the recovery from sputtering out. A string of developments, including the weak jobs report last Friday, has altered the sentiment within the central bank, leading Fed policy makers to stop worrying for the moment about the increasingly remote prospect of inflation. Instead, they are increasingly focused on the potential for the economy to slip into a deflationary spiral of declining demand, prices and wages.
Economists, including former Fed officials, say the central bank’s interest rate policy committee is likely, at the least, to acknowledge the slowdown in the recovery, and to discuss steps like reinvesting the proceeds from its huge mortgage-bond portfolio, which could help the economy by keeping more money in circulation. Not since 2003 has the prospect of deflation been taken so seriously at the Fed, and not since the 2008 financial crisis have the markets been looking so closely to it for guidance. With Congress unwilling to embark on substantial new stimulus spending, the Fed has the only tools likely to be employed anytime soon in response to the economic warning signs.
The Fed’s chairman, Ben S. Bernanke, and other officials believe that the Fed, having lowered interest rates all the way to zero in 2008, still has the ability to avoid deflation. But they are also concerned that any new dose of monetary medicine could carry unintended side effects, making it harder to normalize policy in the future. Complicating matters, a vocal minority of Fed officials is skeptical that deflation — a spiral of falling wages and prices, which Japan’s economy has experienced since the 1990s — is even a worry. "The outcome of this meeting is more uncertain than in any in at least the last year," said Laurence H. Meyer, a former Fed governor.
At the Fed’s last meeting, in June, the prospect of deflation was discussed for the first time this year. Alan Greenspan, the Fed chairman for 18 years until he retired in 2006, said Friday that the economic outlook had darkened. "It strikes me as a pause in the recovery, but a pause in this type of recovery feels like a quasi-recession," he said. He added: "At this particular moment, disinflationary pressures are paramount. They will not last indefinitely."
Mr. Greenspan said there had been "some evidence of a pickup in inflation" until the Greek debt crisis took hold in the spring. But the resulting uncertainty drove down long-term interest rates — the yield on the benchmark 10-year Treasury note fell to 2.82 percent on Friday, the lowest level since April 2009, and barely budged Monday — in a reflection of what Mr. Greenspan called continuing problems in the financial markets. Mr. Greenspan declined to make recommendations or predictions for Fed policy, but on Wall Street, there is already talk that the Fed could begin a new round of quantitative easing — buying financial assets to hold down long-term interest rates and increase the supply of money.
Jan Hatzius, chief United States economist for Goldman Sachs, predicted on Friday that the Fed would begin a new round of asset purchases — which could include at least $1 trillion worth of Treasury securities — late this year or early next year. He revised down his forecast for the growth of gross domestic product in 2011 to 1.9 percent from 2.4 percent. He also predicted that unemployment would hit 10 percent in the second quarter of next year.
Among the voting members of the central bank’s policy-setting Federal Open Market Committee this year, the presidents of the Fed’s Boston and St. Louis district banks have warned recently about the threat of deflation, while the Kansas City bank president is known for his view that inflation, the Fed’s traditional enemy, remains the greatest threat. But it is Mr. Bernanke who holds the most say over the outcome.
Randall S. Kroszner, a former Fed governor, said the committee was certain to alter its outlook in its statement on Tuesday. "I think the language will broadly change to acknowledge the moderation in the pace of the recovery," he said. Mr. Kroszner said it seemed increasingly likely that the Fed could announce that it would reinvest the cash it receives as the mortgage bonds it holds mature, rather than letting its balance sheet gradually shrink over time.
In March, the Fed completed its purchase of $1.25 trillion in mortgage-backed securities. A decision to reinvest the bond proceeds in other mortgage-related securities, or in Treasuries, would be largely symbolic but carry great weight, as it would signal concern about the economy, and also make clear that an "exit strategy" from easy monetary policy was not imminent. The Fed might also be poised to discuss two other options: lowering the interest rate it pays on the roughly $1 trillion in reserves that banks are keeping at the Fed in excess of what they are required to, and altering the "extended period" language it has been using to describe how long short-term interest rates will remain at "exceptionally low" levels.
Frederic S. Mishkin, another former Fed governor, said that most recoveries hit speed bumps, and that economic indicators contained considerable statistical "noise." He said the Fed would be prudent not to overreact. "It’s not clear the Fed needs to ease at this point," Mr. Mishkin said. "If the recovery gets back on track they are still going to have to worry about an exit strategy. Quantitative easing is not a trivial matter. The expansion of the balance sheet leads to many complications for the Federal Reserve." But Mr. Meyer, the former Fed govenor, said the committee should take into account not just the probability of various outcomes, but the potential damage associated with each of them.
"Because the cost of a slowdown in growth is so dramatic relative to that of higher inflation, they should follow the risk-management strategy that Greenspan espoused during the last deflation scare," he said. During that period, in 2002-3, the Fed kept interest rates low, as the economy recovered from the 2001 recession, to guard against deflation. Those fears did not come to pass. But some now say the Fed kept rates too low for too long, feeding the housing bubble. "It is by no means a slam dunk," Mr. Meyer said of the Fed’s decision.
Fed could 'climb aboard QE2' to boost stalled US recovery
by James Quinn - Telegraph
Just days after the US annualised growth rate was found to have slowed from 3.7pc in the first quarter to 2.4pc in the second, and amid continuing concerns about the strength of the rebound in the housing market, for Geithner to write "we are coming back" was seen as ill-judged. The Atlantic, the weekly US news magazine, called the piece "Tim Geithner's pathetic case for optimism" while one of the New York Times' own readers – a Susan McGregor of Rhode Island – wrote in to say she believed that rather than recovery "a temporary remission" would have been "more accurate".
After last Friday's non-farm payroll figures – showing the US economy lost 131,000 jobs in July, the second consecutive monthly fall – and Goldman Sachs' subsequent 2011 growth downgrade, Geithner's comments looked even more out of step. Just how out of step will be revealed at 7.15pm on Tuesday, when the Federal Reserve's Open Markets Committee gives its latest prognosis on the state of the US economy.
In what will be one of the most closely watched meetings in some time, FOMC is likely to hold rates at 0pc-0.25pc – for the 17th time in a row. But it is not for a potential rate change that investors will be watching. Instead, as Goldman Sachs' Ed McKelvey coyly put it, it is whether the Fed will be "climbing aboard QE2 to avoid a double dip?" The QE2 in question is not the ocean liner – but a second bout of quantitative easing designed to kick-start the economy to prevent it sinking back into another period of negative growth.
Paul Sheard, Nomura's chief global economist, was the first Wall Street economist to argue that Ben Bernanke, the Fed's chairman, and his nine FOMC colleagues should take some form of affirmative action to get the US recovery back on track. Sheard, in a note published a week ago, argued that the most likely action is for the Fed to "at least stop the passive contraction of its balance sheet". His comments followed those of James Bullard, president of the St Louis Federal Reserve and a voting member of the FOMC, who said the central bank needs some form of quantitative easing plan.
Of course, as McKelvey points out, the Fed has been here before. The first round of quantitative easing saw the Fed buy $1.7 trillion (£1.1 trillion) of mortgage-related bonds and US Treasuries to resuscitate the economy. Until now, the process was largely thought to have worked, allowing the Fed to slowly rein in its activities – reducing its balance sheet from the $2.3 trillion it reached at its peak. But economists are now questioning whether the Fed moved too soon. Speaking before the US Congress last month, Bernanke detailed three ways in which the central bank might step in if needed.
The first was as outlined by Sheard, the second was restarting the asset purchase programme, while the third – the weakest of all perhaps – would be to change the language in the FOMC's much-analysed statement after Tuesday's or subsequent meetings to point out that deflation will not be tolerated. David Rosenberg, chief economist at Gluskin Sheff and one of the earliest economists to make the deflation "call", noted that "there is growing chatter that the Fed is once again going to come to the rescue".
Indeed the rumour mill includes some form of mortgage-relief scheme to help borrowers suffering from negative equity, while there is also talk of the Fed detailing a new $2 trillion easing programme. There is also talk in Washington of the Fed recycling money redeemed from its earlier easing programme into a new series of asset purchases. But, despite of the flurry of recent negative economic data, not everyone on Wall Street believes it is time for the Fed to act. Simon Hayes, economist at Barclays Capital, says he has "detected no change" in the Fed's tone in recent weeks, while economist Tom Higgins at Payden & Rygel argues that a double-dip recession remains a "low probability" and as a result the Fed is unlikely to act to "boost economic activity".
Goldman's McKelvey disagrees, however, predicting the Fed will "embrace a new asset purchase programme" if not on Tuesday then at the turn of the year. It will have to be at least $1 trillion to "have a meaningful effect", he claims. Amongst all this economic debate about the status of the US recovery, it is worth noting that the US National Bureau of Economic Research – the independent arbiter of US business cycles – has yet to declare an end to the 2007-09 recession, meaning that whatever the Fed chooses to do, the US is not quite ready hang up the "Welcome to the recovery" bunting just yet.
The Worrying Numbers Behind Underwater Homeowners
by Charles Hugh Smith - Daily Finance
By the end of the first quarter of 2010, the number of mortgaged residential properties with negative equity had declined slightly to 11.2 million, down from 11.3 million at the end of 2009, according to a report issued by real estate analytics firm CoreLogic. The report includes data through the first quarter, and is CoreLogic's most recent available study.
The bad news: Those 11.2 million loans make up roughly 24% of all U.S. mortgages. Add the 2.3 million borrowers who are close to slipping underwater (those with less than 5% equity), and the numbers rise to 13.5 million -- 28% of mortgages.
This aligns with other industry estimates. Earlier this year, Mark Zandi, chief economist at Moody's Economy.com, estimated that roughly 15 million American homeowners owe the bank more than their home is worth. (Note: On Aug. 9, Zillow Real Estate Market Reports said the percentage of single-family homes with negative-equity mortgages fell to 21.5% in the second quarter, from 23.3% in the first quarter, due mostly to higher foreclosures in the period.)
Calculating how many households are underwater, how far underwater they are and how many others are at risk of sliding into negative equity should housing values decline further is critical to forecasting future foreclosures, a recovery in housing values and the financial health of U.S. households.
Negative Equity Boosts Foreclosure
The data confirms the common-sense expectation that there's a direct correlation between negative equity and foreclosures: As the number of homeowners who are underwater rises, so do foreclosures.
Many homes are worth only half of their mortgages. There are 4.1 million homeowners with more than 50% negative equity and another 5 million homeowners with 20% to 50% negative equity.
So the majority of the 11.2 million properties with negative equity (9.1 million) are deeply underwater and are thus unlikely to be made whole by modest increases in home prices. That makes further increases in foreclosures likely, and so it's unsurprising that Economy.com expects that this year's foreclosures will swell to 2.4 million.
How Many Homes Could End Up Underwater?
If prices decline into 2011, as some analysts project, how many homes could slip into negative equity?
According to the U.S. Census Bureau, as of 2008, 51 million households had a mortgage, 24 million owned homes free and clear (no mortgage) and about 37 million households rented their homes.
In 2008 and 2009, foreclosures dissolved roughly 4 million mortgages, reducing the total number of outstanding mortgages to around 47 million. The total number of U.S. home-owning households stand at about 71 million.
The data presented by CoreLogic backs up these conclusions:
- The highest percentage of homes with negative equity are concentrated in the states that experienced the most extreme price increases and the subsequent severe declines in valuations: Nevada, Arizona, Florida and California.
- Though the media focuses on the "bubble" states, many other states also have high rates of negative equity: Over 20% of homeowners in Virginia, for example, are underwater, and an additional 5.7% are in near-negative equity territory.
- Properties with more than one mortgage -- those with second mortgages or home equity lines of credit (HELOC) on top of first mortgages -- were twice as likely to be underwater than those with only a first mortgage (38% vs. 19%).
What is surprising is how few homes have conventional 30-year mortgages that require a down payment. An analysis I performed in 2007 found that only 12 million of the roughly 48 million homes with mortgages had only a conventional fixed 30 year mortgage and no additional liens.
So only 25% of all homes with mortgages had what was once the only loan available, the conventional 30 year fixed mortgage supported by a 20% cash down payment.
The other 75% of mortgaged homes had loans that greatly increased the risk of falling into negative equity or delinquency:
- Low-down-payment mortgages -- as low as 3% for Federal Housing Administration (FHA)-backed loans. The FHA recently reported that fully 24% of its vast portfolio were "problem loans" -- seriously delinquent or in default.
- "Exotic" subprime loans
- Adjustable-rate mortgages that can reset to much higher payments after a few years
- Two mortgages -- a first mortgage and a "junior lien" such as a second mortgage or a home equity line of credit (HELOC)
All this suggests that only 25% of mortgages -- those with 30 year fixed-rate mortgages -- are at low risk of negative equity. The remaining 75% -- mortgage holders at higher risk of negative equity or already underwater -- number about 35 million households and make up around half of total home-owning households (71 million). Of the 50% of homeowners with risky loans, some 11 million are already underwater.
The Equity Gap
According to the latest Federal Reserve Flow of Funds report, there was $10.24 trillion in U.S. residential mortgages and $16.5 trillion in total home equity.
Since there are about 47 million outstanding mortgages, and 24 millions homes owned free and clear (no mortgage), then we can calculate that free-and-clear owners hold about a third of the $16.5 trillion in home equity -- roughly $5.3 trillion. That leaves about $1.2 trillion in equity spread amongst the 47 million homes with mortgages.
Given the likelihood that those with a conventional fixed-rate mortgage are most likely to have substantial equity, then it follows that this $1.2 trillion in equity is concentrated in the 12 million homes with conventional mortgages.
Subtract the 11 million homeowners who are underwater and have no equity, and that suggests that the remaining 25 million homeowners with exotic, adjustable or multiple mortgages have relatively little equity.
A recent analysis of long-term U.S. real estate data concluded that over time, the nation's housing equity (collateral) can sustain a mortgage load of approximately 40% of total equity. Thus in 1990, $6 trillion of housing collateral supported $2.5 trillion of mortgages, and the $23 trillion of housing collateral in 2006 sustained $10 trillion of mortgages.
Since then, equity has fallen $7 trillion to $16.5 trillion, but mortgages have barely declined -- they remain at $10.24 trillion. To revert to the long-term trend, mortgages will have to decline by $4 trillion to about $6 trillion.
The conclusion: Never before have American homeowners with mortgages held such a thin slice of equity, and never before have so many homeowners been at risk of negative equity. Predicting accurately how many homeowners end up underwater is impossible, as the future of home prices is unknown. But anyone claiming that the number of underwater homes can't rise further is on thin ice.
Fannie Mae Seeks $1.5 Billion in Aid
by Shanthi Venkataraman - The Street
Fannie Mae requested an additional $1.5 billion of funds from the U.S. Treasury to meet its net-worth deficit after it reported a loss for the second quarter. That would raise Fannie Mae's total bailout from the Treasury to $86.1 billion, including the $8.4 billion worth of funding it received to plug its deficit in the first quarter. The country's biggest residential mortgage financier, Fannie Mae reported a net loss of $3.1 billion or 55 cents per share for the second quarter, lower than its loss in the year-ago quarter of $15.1 billion or $2.67 per share. The Fannie Mae loss figure includes $1.9 billion of dividends paid on its senior preferred stock held by Treasury.
Revenue rose to $4.5 billion, 13% higher than the year-ago quarter and 49% higher than the first quarter of 2010 for Fannie Mae. Fannie Mae reduced its losses on the back of a decrease in the rate of seriously delinquent loans in the second quarter to 4.9% from 5.7% in the first quarter. Credit-related expenses declined 75% to $4.85 billion from the year-ago quarter. The company expects credit-related expenses to remain elevated through 2010.
The government took control of the government-sponsored mortgage financiers, Fannie Mae and Freddie Mac, in 2008 after toxic mortgages threatened to swallow their capital reserves. The agencies have received about $145 billion in bailout money since then. While most banks have managed to repay bailout funds and even ratchet up profits, Fannie Mae continues to turn in losses -- and the likelihood of taxpayers getting back their full investments has become increasingly dim.
So far the government has been unable to figure out a way to resolve the problems of Fannie Mae and Freddie Mac without rocking the housing market. Even as their losses mount, both the agencies, which control over half the U.S. residential market, have continued to guarantee and insure loans as well as re-modify them for borrowers struggling to pay off their debt. That has helped prop the housing market and send mortgage rates to record lows.
During the first half of 2010, Fannie Mae purchased or guaranteed $423 billion in loans, which includes approximately $170 billion in delinquent loans the company purchased from its single-family mortgage-backed securities trusts. Since January 2009, Fannie Mae has helped finance 4.1 million single-family loans and 487,000 multi-family units. In the second quarter, Fannie Mae completed home retention workouts (modifications, repayment plans and forbearances) for more than 132,000 loans, 26% higher than the number of those completed in the first quarter.
Fannie Mae estimates that home prices improved 2.2% in the second quarter. It expects housing prices to decline slightly for the balance of 2010 and 2011 before stabilizing and that home sales will be flat for 2010. "Across our industry, we are seeing a more realistic approach to housing and lending that bodes well for the future," said CEO Mike Williams. "At Fannie Mae, we are committed to maintaining appropriate standards while also supporting affordable housing for low- and middle-income families. We will also continue to support a variety of programs to reach borrowers who need help, so that whenever possible, they can avoid foreclosure and stay in their homes," he said. The penny stock shed nearly 9% on Thursday to close at 36 cents.
Freddie Mac Swings to Loss, Seeks More Aid
by Nick Timiraos - Wall Street Journal
Freddie Mac reported a second-quarter net loss of $4.7 billion and asked the U.S. Treasury to provide a $1.8 billion infusion, raising the government's tab for its rescue of the mortgage-finance company to $63.1 billion. The second-quarter loss, the 11th in the last 12 quarters, compared with a year-earlier net profit of $300 million. Credit losses at Freddie remained high, at $5 billion, though that was down slightly from past quarters as borrowers fell behind on their mortgages at a slower pace and as home prices improved.
But low interest rates led to a $3.8 billion loss on derivatives and the company posted a $900 million charge due to an error in how it had been accounting for its backlog of delinquent loans. Freddie Mac and its larger cousin, Fannie Mae, continue to bleed money largely because of loans that were made as the housing boom turned to bust. As loans turn delinquent, the companies must set aside more money for future losses that they could take as homes sell through foreclosure.
Analysts are split over how soon the companies might stop losing money. In recent months, falling delinquencies and home-price stabilization have led to some signs that the companies' worst losses have passed. "Maybe they are seeing some light at the end of the tunnel. Whether it's sunlight or something else, that's the argument," says Brian Harris, senior vice president at Moody's Investors Service.
At Fannie, the volume of nonperforming loans fell during the second quarter by nearly 3% to $217 billion, though that was still up 22% from a year ago. But nonperforming-loan volumes at Freddie continued to rise during the second quarter to $118 billion, up 2% for the quarter and 36% from a year earlier. So far, Freddie has reserved about 32 cents for every dollar in nonperforming assets, while Fannie has reserved about 27 cents. That makes the companies "massively underreserved," says Paul Miller, an analyst with FBR Capital Markets. "There's a lot more losses coming our way with these companies."
The prospect of additional home-price declines adds to the cloudy outlook. Any unforeseen decline "will just start that process up again where they'll have to be aggressively increasing their reserves," says Mr. Harris. Another drop in values would not only lead to more delinquent borrowers with fewer options to avoid foreclosure, but it could also force Fannie and Freddie to take bigger losses on the growing mound of homes that the companies are recovering through foreclosure.
The inventory of homes owned by the companies has doubled over the past year, to a combined 191,000, up from 97,000 a year ago. Fannie and Freddie also face a difficult balancing act in selling those repossessed properties without putting further pressure on home values. "If housing continues to decline and the jobs picture stays weak or gets weaker then...the goal posts keep getting moved away," says Jay Diamond, managing director of Annaly Capital Management.
The U.S. took over Freddie and Fannie two years ago through a legal process known as conservatorship and has pledged to inject unlimited sums of aid over the next three years to keep the companies afloat. Fannie last week asked the government for $1.5 billion, bringing the total tab for the companies' rescue to $148 billion. Those injections will become expensive because the firms must pay the government a 10% dividend.
Assuming that the companies had the same average after-tax earnings during the decade preceding their losses, it would take more than 18 years to pay off the government, according to an estimate by Anthony Sanders, professor of real-estate finance at George Mason University in Fairfax, Va. The financial-regulatory overhaul that President Barack Obama signed into law last month didn't directly address the future of Fannie and Freddie. The Obama administration said it will put forward a detailed plan early next year and will start that process at a conference in Washington next week. But analysts said that the final resolution of the firms' fates could still be years away.
The Return of the $1,000 Down Mortgage
by Annie Lowrey - Washington Independent
Fannie Mae and State Housing Agencies Are Offering Little-Money-Down Mortgages. But Why?
"Buy new with $1,000 down," the advertisement says, the words resting atop a trim green clapboard house offset by a bright blue sky. "The time has come. Stop wasting rent check after rent check and start building equity in your own home. And with only $1,000 down, affordable monthly payments and no private mortgage insurance required, the dream is closer than you think."
It sounds too good to be true. But it is true. This offer does not come from a subprime lender, looking to reel in thousands of unqualified and ill-advised homebuyers, only to slap them with add-ons, fees and variable rates. It is not a teaser or a trick. The advertisement references a program initiated by the National Council of State Housing Agencies and Fannie Mae, the taxpayer-backed, government-sponsored enterprise that buys up mortgages from lending banks.
The pilot program is called "Affordable Advantage," and it has now been adopted by three states — Massachusetts, Wisconsin and Idaho. (Other states, such as Pennsylvania, California and Colorado, have similar state programs.) The initiative is small, reaching just a few hundred people so far. But it is looking to expand. Given the dangers of these types of mortgages and the specter of the housing bubble, where unconventional loans wreaked disaster, it is also raising questions from wary housing experts and legislators.
Fannie Mae helped to create Affordable Advantage after the state government agencies tasked with expanding homeownership found they were having trouble doing their job. Before the recession hit, these housing finance agencies, known as HFAs, issued tax-free bonds and used the funds on programs to encourage developers to build in underserved areas and to support single-family mortgages. When the financial crisis hit, private companies — leery of the collapsing housing bubble and freezing mortgage market — no longer wanted to buy the HFAs’ bonds. Their business ground to a halt.
To help HFAs move forward, Fannie Mae and NCSHA stepped in. Fannie Mae agreed to purchase mortgages with tiny down payments, as long as the homebuyers were vetted — had excellent employment histories and credit, and merely lacked a cash reserve for a down payment. And the participating HFAs agreed to buy back loans if they became delinquent, in lieu of Fannie asking for more-traditional mortgage insurance.
"[The program] was created to support state HFAs and their efforts to provide qualified first-time homebuyers with financing in the wake of the housing and economic downturn," Janis Smith, a Fannie Mae spokesperson, says. "HFAs are nationally regarded leaders in affordable housing finance and their business is prudent, sustainable business. HFAs work closely with their borrowers to ensure they’re well prepared for homeownership. As a result, the loans delivered by HFAs have very low delinquency rates. In addition, HFAs work with first-time homebuyers who need and are qualified for affordable housing — a segment that has seen increased demand with the downturn in the housing market."
Now, qualified homebuyers in the three states pioneering Affordable Advantage do not need to put down the 3.5 percent minimum down payment required by the Federal Housing Administration, or much of a down payment at all. They can get 100 percent financing — a loan as big as the purchase price of the house — for a 30-year, fixed-rate mortgage — a vanilla mortgage. The deal includes a program to help homebuyers if they become unemployed, lowered fees and there is no requirement that the homebuyer purchase mortgage insurance.
Wisconsin started the program first, in March, offering 100 percent loan-to-value mortgages for borrowers with a minimum credit score of 680. "It’s a good credit score," explains Kate Venne, the spokesperson for the Wisconsin HFA. "In addition, we want to see what other lines of credit people have, and their performance. We look at their work history. We call their employers." Thus far, Wisconsin’s HFA has offered $52 million in mortgages to 450 buyers.
But there are concerns and problems intrinsic to purchasing a home with almost no money down. First and foremost, if the housing market turns down even a fractional amount, the homeowner will go "underwater" immediately. If the price of the house falls by even a bit, he will owe more on the mortgage than the house is worth. If he needs to sell it, he needs to come up with extra cash to pay the bank back. And the fact that the homeowner only had a thousand dollars to put down in the first place implies that he does not have much financial breathing room and might default.
"That is clearly a worry," says Barry Zigas, the director of housing policy for the Consumer Federation of America. "But for people who are buying a home first and foremost as a place to live, the fact there might not be much equity, or the equity might go negative — that’s not the most important feature." He argues that vetted low-income buyers have excellent track records in terms of default, as long as they are invested in their communities and have good employment and credit histories, if not savings. "The more equity you bring to your transaction, the more security you bring. But this can be a great way for people to gain access to homeownership who might not have been able to otherwise. And with mortgage rates what they are" — at historical lows — "this program lets those specific people gain mortgages."
Others disagree. "Haven’t they noticed what’s happened to the country in the past five years?" asks Dean Baker, the co-director of the Center for Economic and Policy Research. "You’re not necessarily helping if you’re helping them buy a home where they’re in the position they won’t be able to afford it. I don’t understand the logic of this. House prices are still going to fall. And when they do, we haven’t helped these people who are going to have to work like crazy to pay their mortgage off, or they’re going to default. If you’re in a situation where this is the only mortgage you can get, you shouldn’t be buying a house."
And many of the governments’ own economists believe that houses should not be many Americans’ primary investment. Karen Pence, who leads the Federal Reserve’s real estate finance research group, argues that homes are a terrible investment and believes the government should offer fewer programs and incentives to subsidize homeownership. On top of that, Affordable Advantage raises questions since, at the end of the day, taxpayers are backing its investments — Fannie Mae being under the government’s conservatorship, and Treasury being the main purchaser of bonds from the state HFAs. In recent months, the government has turned away strongly from programs helping encourage mortgages with low down payments.
The Federal Housing Administration, for instance, considered a plan to let homebuyers use the Obama administration’s $8,500 first-time homebuyer tax credit to cover the 3.5 percent minimum required down payment. It received such push-back from the Hill, incensed the federal government would pay homeowners to have no skin in the game, and from housing experts, that the Department of Housing and Urban Development pulled the program. Indeed, faced with a 14 percent delinquency rate, the Federal Housing Administration increased the premiums it charges to insure some mortgages this year. And it set down payment requirements at 10 percent for borrowers with low credit scores.
On the Hill, increasing numbers of legislators want to ban mortgages with low down payments outright. Rep. Scott Garrett (R-N.J.) last year introduced legislation requiring FHA borrowers to put down 5 percent at least. This spring, Sen. Bob Corker (R-Tenn.) requested an amendment to the financial regulatory reform bill requiring minimum 5 percent down payments for private mortgages. Multiple legislators from both sides of the aisle have recommended looking at down-payment reform for Fannie and Freddie.
Low-income housing advocates argue that the state programs have much lower default rates than the national average, because the state HFAs had good track records of checking out prospective candidates and offering loans only to good ones. Kate Venne, of the Wisconsin HFA, says its default rate is just 1.83 percent. But more and more believe that the products are simply too dangerous, and that the government should no longer boost homeownership for Americans without the means to put at least 3.5 percent down.
"In today’s world, without question, we’ve learned two lessons," FHA Commissioner David Stevens told reporters this winter. "One: homeownership is important to the sustainability of communities. And two: not everybody should own a home."
by Megan McArdle - The Atlantic
If you want to know why us libertarian types are skeptical of the government's ability to prevent housing market bubbles, well, I give you Exhibit 9,824: the government's new $1000 down housing program.
No, really. The government has apparently decided, in its infinite wisdom, that what the American economy really needs is more homebuyers with no equity.Now, qualified homebuyers in the three states pioneering Affordable Advantage do not need to put down the 3.5 percent minimum down payment required by the Federal Housing Agency, or much of a down payment at all. They can get 100 percent financing -- a loan as big as the purchase price of the house -- for a 30-year, fixed-rate mortgage -- a vanilla mortgage. The deal includes a program to help homebuyers if they become unemployed, lowered fees and there is no requirement that the homebuyer purchase mortgage insurance.
Wisconsin started the program first, in March, offering 100 percent loan-to-value mortgages for borrowers with a minimum credit score of 680. "It's a good credit score," explains Kate Venne, the spokesperson for the Wisconsin HFA. "In addition, we want to see what other lines of credit people have, and their performance. We look at their work history. We call their employers." Thus far, Wisconsin's HFA has offered $52 million in mortgages to 450 buyers.
Now, commentators left and right can agree that this is not a good idea. No matter how stable said low-income homeowners are, they shouldn't be buying houses with no equity, because if they suddenly have to sell said houses, they're going to have trouble coming up with 6% to pay the broker, closing costs, etc.
So why is the government doing this, even though I can think of no policy analyst who doesn't actually work for the National Association of Realtors who would say that this is a good idea? Because politicians want to help poor people with capital formation, and homeownership is the way that the American middle class has traditionally gone about capital formation.
It's true that this particular program is small--I don't think the economy is going to be brought to its knees by several hundred houses. The important thing, however, is that this is how the government thinks about housing. The private bankers have at least reacted to their little scare by getting somewhat more conservative about the loans they offer--probably not conservative enough, but still, more conservative. The FHA, on the other hand, is still out there offering 3.5% mortgages to anyone who can meet some fairly basic guidelines; those mortgages now account for almost 20% of all home purchases. Yet so far, the FHA has cracked down in only one area: it now requires a 10% downpayment from buyers with very bad credit. On the other hand, it's also expanded into pricier homes, so I'm not sure you can say the loan criteria have tightened overall.
The private bankers have to tighten, because they need to protect themselves. The government is less worried about protecting itself from default than protecting itself from voters who want to buy a home at cheap rates. Small wonder they've decided to "help" low income homeowners into dangerous loans.
Freddie, Fannie and the Third Rail of Housing Policy
by Gretchen Morgenson - New York Times
While Congress toiled on the financial overhaul last spring, precious little was said about Fannie Mae and Freddie Mac, the mortgage finance companies that collapsed spectacularly two years ago.
Indeed, these wards of the state got just two mentions in the 1,500-page law known as Dodd-Frank: first, when it ordered the Treasury to produce a study on ending the taxpayer-owned status of the companies and, second, in a "sense of the Congress" passage stating that efforts to improve the nation’s mortgage credit system "would be incomplete without enactment of meaningful structural reforms" of Fannie and Freddie. No kidding.
With midterm elections near, though, there will be talk aplenty about dealing with the companies precisely because Dodd-Frank didn’t address them. Unfortunately, if past is prologue, this talk is likely to be more political than practical. Fannie and Freddie amplified the housing boom by buying mortgages from lenders, allowing them to originate even more loans. They grew into behemoths because they lobbied aggressively and played the Washington political game to a T. But after both companies bought boatloads of risky mortgages, they required a federal rescue.
The Treasury’s study on Fannie, Freddie and housing finance must be delivered to Congress by the end of January 2011. In a speech last week, Timothy F. Geithner, the Treasury secretary, told a New York audience that resolving the companies isn’t "rocket science." But attaining genuine remedies for our housing finance system could actually be harder than rocket science. That’s because it would require an honest dialogue about the role the federal government should play in housing. It also requires a candid conversation about whether promoting homeownership through tax policy and other federal efforts remains a good idea, given the economic disaster we’ve just lived through.
Alas, honest dialogues on third-rail topics like housing have proved to be a bridge too far for many in Washington. So, what we may hear instead about Fannie and Freddie before the elections is a lot of sound and fury signifying a stealthy return to the status quo. This would be unfortunate, not only because the financial crisis presents a rare opportunity to reassess the supposed benefits of homeownership but also because there was a lot not to like about the way these companies operated and the ways their friends in Congress enabled that behavior.
Outwardly, Fannie and Freddie wrapped themselves in the American flag and the dream of homeownership. But internally, they were relentless in their pursuit of profits from partners in the mortgage boom. One of their biggest and most steadfast collaborators was Countrywide, the subprime lending machine run by Angelo R. Mozilo. Countrywide was the biggest supplier of loans to Fannie during the mania; in 2004, it sold 26 percent of the loans Fannie bought. Three years later, it was selling 28 percent. What Countrywide got out of the relationship was clear — a buyer for its dubious loans. Now the taxpayer is on the hook for those losses.
But what was in it for Fannie? An internal Fannie document from 2004 obtained by The New York Times sheds light on this question. A "Customer Engagement Plan" for Countrywide, it shows how assiduously Fannie pursued Mr. Mozilo and 14 of his lieutenants to make sure the company continued to shovel loans its way. Nine bullet points fall under the heading "Fannie Mae’s Top Strategic Business Objectives With Lender." The first: "Deepen relationship at all levels throughout CHL and Fannie Mae to foster alignment and collaboration between our companies at every opportunity." (CHL refers to Countrywide Home Loans.) No. 2: "Create barriers to exit partnership." Next: "Disciplined Risk/Servicing Management" and "Achieve Fannie Mae Profitability Goals."
(Later in 2004, by the way, the Securities and Exchange Commission found that Fannie had used improper accounting and ordered it to restate its earnings for the previous four years. Some $6.3 billion in profit was wiped out.) The engagement plan also recommends ways that Fannie executives should mingle with Countrywide’s top management, because "fostering more direct senior level engagements with key influencers throughout their organization will be beneficial in ensuring strategic alignment and building organizational loyalty."
Recommendations included conferring with Mr. Mozilo at Habitat for Humanity golf tournaments and Mortgage Bankers Association conventions. Franklin D. Raines, then Fannie’s C.E.O., and Daniel H. Mudd, then its chief operating officer, were advised to see Mr. Mozilo twice a year. "We will be successful when Angelo influences the industry or his organization on our behalf," the document says. Mr. Raines didn’t respond to e-mails requesting comment last Friday; he left Fannie in December 2004.
The memo advised pursuing other Countrywide executives: "Deep Rapport" should be the goal with David E. Sambol, the lender’s president, but because he did not "heavily attend outside events" Fannie executives should "look for opportunities for meetings" at Countrywide headquarters. "We will be successful if we can foster ongoing communication channels that allow us to understand and leverage Sambol’s priorities and demonstrate our commitment to making him successful," the memo stated. Mr. Sambol and Mr. Mozilo could not be reached for comment.
For his part, Mr. Mudd, now the chief executive of the Fortress Investment Group, said Fannie’s courting of Countrywide was not unusual. "We tried to build a program that was based on having multiple strong relationships with our main customers," he said. "You want to be sure that the first call is not the last call, that a customer is not doing business with you anymore." But Representative Darrell Issa, a California Republican and ranking member on the House Committee on Oversight and Government Reform, says he has concerns about such mating dances.
"Lost in the debate over how best to legislate the aftermath of the financial crisis has been the necessity to conduct an inward examination of the too-cozy relationship between government enterprises and private industry," Mr. Issa said. "The true nature of this strategic partnership between Countrywide and Fannie-Freddie should be exposed so we can measure the extent to which it fostered the conditions leading to the financial meltdown."
Understanding how these companies operated is crucial if we want to avoid repeating the mistakes of our recent past. So, when you hear about Fannie and Freddie reform this fall, remember that we still don’t know the half of it.
'Buy and Bail' Homeowners Get Past Mortgage Hurdles From Fannie, Freddie
by Kathleen M. Howley - Bloomberg
Harvey Collier, a mortgage broker in Fort Lauderdale, Florida, says he gets as many as 10 calls a month from people planning to default on their loans. The twist: They first want financing to buy another home. Real estate professionals call it "buy and bail," acquiring a new house before the buyer’s credit rating is ruined by walking away from the old one because it’s "underwater," or worth less than the mortgage. It’s an attempt to escape payments on a home whose value may never recover while securing a new property, often at a lower price with a more affordable loan.
The practice, which constitutes fraud if borrowers lie on loan applications, is continuing even after Fannie Mae and Freddie Mac, the biggest U.S. mortgage-finance companies, beefed up standards to prevent it, according to brokers such as Collier and Meg Burns, senior associate director for congressional affairs and communications at the Federal Housing Finance Agency. Whether driven by greed or desperation, the persistency of buy and bail underscores the lingering impact of the worst housing crash since the Great Depression.
"People were holding on, hoping the market would turn around," Collier, who won’t work with applicants who intend to go into foreclosure, said in a telephone interview. "But now they’re giving up because there’s no light at the end of the tunnel in places like Florida."
The value of U.S. homes fell by a third from 2006 to 2009, as tracked by the S&P/Case-Shiller index. In some areas, the losses were bigger. Prices declined 56 percent in Las Vegas, 55 percent in Phoenix and 49 percent in Miami. Such declines have left more than a fifth of single-family homeowners with mortgages underwater in the second quarter, according to a report yesterday by Zillow.com, a Seattle-based data company.
Rising Strategic Defaults
About 12 percent of residential-loan defaults in February were strategic, meaning homeowners decided not to make payments even though they could afford to, New York-based Morgan Stanley said in an April 29 report. The rate, which was about 4 percent in mid-2007, probably will increase even if home values start to recover, said Frank Pallotta, managing partner of Loan Value Group, a mortgage-consulting firm in Rumson, New Jersey. "After home prices bottom, the borrower in a position of negative equity is able to quantify exactly how long it will take to recoup the loss, and may decide to walk away," Pallotta said.
Most likely to walk away are borrowers with the best credit scores and so-called jumbo loans that exceed the caps set for mortgages bought by Fannie Mae and Freddie Mac, which range from $417,000 in most locations to $729,750 in high-cost areas, according to the Morgan Stanley report. People who choose to default typically have lost $100,000 or more in property value, said Brent White, a law professor at the University of Arizona in Tucson. No data exist on strategic defaults done in tandem with buy-and-bail purchases.
Buy and bail is most often pursued by people with big enough paychecks and low enough debt to qualify for two homes, according to Mark Goldman, a broker at Cobalt Financial Corp. in San Diego. That threshold is easier to meet since home prices retreated and mortgage rates fell to an all-time low, he said. The average U.S. rate for a 30-year fixed home loan dropped to 4.49 percent, the lowest in records dating to 1971, McLean, Virginia-based Freddie Mac said on Aug. 5.
"Most people, if they have the means to do it, would like to make sure they have someplace to live before they let a house go into foreclosure," Goldman said. "They know they’re going to kill their credit score, so they make sure to get a home they won’t mind staying in." Freddie Mac and larger rival Fannie Mae cracked down on buy and bail in 2008 by banning in most cases the use of rental income from an existing home to qualify for a new mortgage unless the first property has at least 30 percent equity.
Always A Way
"There were a number of policies put in place to squelch this type of activity, but people who are savvy can always find a way to circumvent policies," said Burns of the Federal Housing Finance Agency, which regulates Fannie Mae, Freddie Mac and the 12 federal home loan banks. In addition to the rental restrictions, the mortgage giants now usually require reserves equal to six months of loan payments for both homes. The measures have helped weed out most applicants who attempt to buy and bail, said Pete Bakel, a spokesman for Washington-based Fannie Mae.
"We’re always looking for ways to discourage the practice of buy and bail, but it still seems to be going on," said Brad German, a Freddie Mac spokesman. "It ultimately leads to higher costs for everyone as investors and others look for ways to price in the risk." Buy and bail is fraud if applicants provide false information to obtain a loan, said Steve Beede, a real estate attorney at BPE Law Group Inc. in Fair Oaks, California. The Federal Bureau of Investigation is pursuing more than 3,000 mortgage-fraud cases, almost double the number from a year earlier, FBI Director Robert Mueller said in a June 17 statement.
"Buy and bail is not the most common mortgage-fraud scheme, but it’s something we are aware of and investigate aggressively," said Stephen Kodak, an FBI spokesman, who declined to give specifics about cases. The bureau works with state police and local housing agencies to conduct investigations, he said. Mortgage lenders often ask about plans for existing properties when vetting borrowers, said Beede, the attorney. Others don’t seem to care, as long as there is enough income to pay both mortgages, he said. The new lender usually has no stake in the first loan, Beede said. Clients of Ron Wilczek, a real estate broker in Tempe, Arizona, two months ago bought a house near Phoenix even though they couldn’t sell their existing property because its value had sunk so far below its mortgage.
Ethics Versus Economics
Now settled in their new residence, they may try to sell the first home for less than what they owe, said Wilczek, owner of Metro Phoenix Homes. If the lender won’t agree to a short sale, they may just stop making payments, he said. "You can make the argument that you must honor your commitments no matter what," Wilczek said. "On the other hand, you have people who are realizing that if they want any hope of a retirement or a better life for their families, they can’t keep paying for something that will never, at least in their lifetimes, regain its value." Even if owners have underwater loans, walking away is unethical, said Scott LeForce, president of Realty World Northern California Inc. "A loss of value doesn’t mean you have permission to run from your obligations," he said.
In about two-thirds of U.S. states, including Florida, lenders may pursue a borrower after foreclosure by seeking a deficiency judgment allowing a lien on new property for the amount still owed on a previous mortgage. In states such as California and Arizona, lenders may not have that option if the original home was a primary residence. "Making it possible to pursue people who do this particular kind of default would go a long way to addressing the buy-and-bail problem," said Jay Brinkmann, chief economist for the Mortgage Bankers Association in Washington.
Foreclosure reduces a Massachusetts home's sale price by 27% on average
by Harvard University
Foreclosure reduces the eventual sale price of a home by an average 27 percent, compared to the prices paid for similar properties nearby. Those nearby homes, in turn, could see their own prices depressed by 1 percent, if they happen to be within 250 feet of the foreclosed property. Those are the findings of economists at Harvard University and the Massachusetts Institute of Technology who scoured records pertaining to 1.83 million Massachusetts home sales from 1987 to 2009. Their research, forthcoming in the journal American Economic Review, is the most rigorous and comprehensive analysis to date of the losses sustained on foreclosed properties.
"The losses on foreclosed homes proved to be much larger than we had expected," says lead author John Y. Campbell, the Morton L. and Carole S. Olshan Professor of Economics at Harvard. "If anything, these results may underestimate losses on foreclosed properties nationwide, since Massachusetts has not experienced a housing boom and bust as pronounced as that seen in many other parts of the country in recent years."
Campbell and his co-authors, Harvard's Stefano Giglio and MIT's Parag Pathak, found that other types of forced sales also reduce home prices, but by smaller amounts. When a house is sold after the death of an owner, they found, the price sinks 5 to 7 percent on average. When an owner declares bankruptcy, the value falls by an average 3 percent. The researchers write that death-related discounts may result from poor home maintenance by older sellers, while foreclosure discounts appear rooted in the greater likelihood of deterioration among foreclosed homes, and specifically the threat of vandalism. They note that the percentage loss on foreclosed properties is greater, on average, in less safe neighborhoods, where risks of damage to vacant homes may be higher.
"Banks know it's bad to hold an asset that's susceptible to damage, and want to unload such assets quickly," Campbell says. "Also, the costs to maintain a house are fixed, but those fixed costs eat up more of the price of a cheap house -- making lenders even more eager to dispose of foreclosed cheaper homes." Campbell and his colleagues found that prices of other homes fall by about 1 percent if within roughly 250 feet of a foreclosed property, an effect that fades away for homes 500 or more feet from a foreclosure. What's more, these "contagion" effects appear to be cumulative, meaning that multiple foreclosed homes in close proximity can depress the value of other nearby properties by several percentage points.
The researchers say their results indicate that public policy should aim to minimize foreclosures, which appear broadly harmful. "Our work provides evidence of genuine social harm arising from foreclosures," Campbell says. "Public policy should discourage reliance on foreclosure as a means of protecting lenders. While foreclosure may rescue lenders, it damages the rest of society."
From Disinflation to Deflation?
by Menzie Chinn - Econbrowser
It's a schizophrenic world. On one side, there are lots of people worried about hyperinflation , despite forward looking indicators of inflation signalling quiescence  and actual price indicators going downward.
On the other are those who actually look at the data, and then conjoin their observations with information on the tremendous slack in the economy, and say that rapid inflation is unlikely. So while all eyes are on this Friday's CPI release, I assert that we don't really have to wait to find out the trajectory of inflation. In this post, I will highlight the fact that over certain horizons, we already have deflation; and for certain segments of the population, inflation has been at zero for a year already.
First, consider standard indicators. The core CPI and core PCE deflator inflation rates are still positive.
Figure 1: Core CPI (blue) 3 month annualized inflation, and core personal consumption expenditure deflator (red) 3 month annualized inflation. Gray shaded area denotes recession, assuming trough at 2009M06. Source: BLS and BEA via FRED II, and NBER, and author's calculations.
For discussion of differences in coverage, weights, and construction between CPI and PCE, see this post. From these conventional indicators, it would seem we are still aways from deflation.
Measures of Inflation, by Income Group
It is important to keep in mind that the impact of price changes on the cost of living differs across income groups, as I discussed in this post. Figure 2 depicts the 3 month annualized growth rate in the CPI as it pertains to the 1st, 3rd, and 5th income quintiles.
Figure 2: Three month annualized inflation calculated using guesstimated CPI ex.-energy for first quintile (blue), third quintile (red), and fifth quintile (green). Guesstimated CPIs calculated as arithmetic averages of component indices; excludes "private transportation" and "fuel and utilities" from the housing component. Source: BLS, and author's calculations based on weights in Kokoski (2003), Table 5.
A caveat: I call these guesstimates because I am not always certain that the categories I have selected match up with the series Kokoski uses in her calculations. In addition, I do not believe that my ex.-"energy" series matches up with the construction of the official CPI excluding energy and fuel series reported by the BLS. I welcome cross-checking. However, I think the deviations of the movements by quintile should be representative.
Clearly, (3 month annualized) inflation for the 5th quintile is very close to stall speed, at about half a percentage point in June 2010. In contrast, inflation being experienced by the 1st income quintile is nearly 1 percentage point. Another way to highlight this difference is to examine the (log) levels of the indices.
Figure 3: Log guesstimated CPI nerg ex.-"energy" for first quintile (blue), third quintile (red), and fifth quintile (green) (2000=0). Guesstimated CPIs calculated as arithmetic averages of component indices; excludes "private transportation" and "fuel and utilities" from the housing component. Source: BLS, and author's calculations based on weights in Kokoski (2003), Table 5.
Notice that the 5th quintile CPI ex.-"energy" is essentially flat since 2009M07. Running a regression on first differences (remember log price indices are at the very minimum I(1), and arguably I(2) over some samples), one finds that the implied annualized inflation rate is 0.3 percentage points, and is not statistically significantly different from zero at the 10% msl. In contrast, the core CPI inflation rate over the corresponding period is 1 percentage point, and is significantly different from zero, with a p-value of 0.015 (both regressions using HAC standard errors, 2 lags).
Why should one care about the 5th quintile? If one is concerned about aggregate consumption, then it is of interest to know what happens to the top 20%. According to Moody's, about 60 percent of total consumption is accounted for by this quintile . If the price level facing this group is falling, then they might either defer consumption in anticipation of yet lower prices, or either increase or decrease consumption in response to changes in wealth (depending on whether they are net creditors or debtors). (The overall CPI weights, according to Deaton, corresponds to about the 75th percentile in income.)
The CPI-all inflation rates (3 month annualized) for the 3rd and 5th quintiles have been negative since May and April respectively. Even that for the 1st quintile has declined as of June. This matches up with the declining inflation for the standard CPI-all, since May.
We know that the CPI is upwardly biased, due to the use of fixed weights for the major categories. That means that if one could apply a Fisher ideal index to these data, for each quintile, one would probably obtain more negative inflation rates. 
We have forward looking market-based indicators of expected inflation. One is the spread between the 5 year Treasury rate and the corresponding 5 year TIPS. Keeping in mind the problems with using the spread to infer inflation , here is the picture.
Figure 4: Difference between five year and five year TIPS constant maturity yields (teal), and five year TIPS constant maturity yields, monthly averages of daily data. Observations for August denote data for August 5, 2010. NBER defined recession dates shaded gray. Source: FREDII and NBER, and author calculations.
With these points in mind, and with tremendous slack in the economy, rapid inflation seems like the last thing one should worry about. Or crowding out, for that matter .
Structured Notes Are ‘Next Bubble,’ Chris Whalen Says
by Zeke Faux and Jody Shenn - Bloomberg
Wall Street banks are creating the "next investment bubble" by selling opaque and unregulated structured notes to investors hunting for yield, according to Christopher Whalen, managing director of Institutional Risk Analytics. Using the same "loophole" that allowed over-the-counter sales of collateralized debt obligations and auction-rate securities, firms are pitching illiquid structured notes whose value is partly derived from bets on interest rates, Whalen wrote today in a report. Whalen, who predicted in March 2007 the collapse of the mortgage-backed securities market, said that these structured notes "promise enhanced yields that go well into double digits" and "often come with only minimal disclosure."
"The only trouble is that the firms originating these ersatz securities, as with the case of auction-rate municipal securities, have no obligation to make markets in these OTC structured assets or even show clients a low-ball bid," Whalen wrote. Dealers say they buy the securities back from investors, providing liquidity, according to Keith Styrcula, chairman of the Structured Products Association, a trade group that organizes industry conferences. The products are used by sophisticated investors to make tailored bets, he said. "While it’s true that firms make clear in the prospectuses that they are under no legal obligation to provide liquidity, they have provided it over the last two decades without a single hiccup," Styrcula said today in a telephone interview.
Based on ‘Nothing’
Structured notes, which are derivatives packaged with bonds, are sold to accredited buyers in private deals and to the public in trades reported to the Securities and Exchange Commission. Sales of the securities to individual investors in the U.S. rose 72 percent from a year ago to $29.6 billion through July, according to StructuredRetailProducts.com, a database used by the industry. "Even as the big banks make a public show for the media of implementing the new Dodd-Frank law with respect to limits on own account trading and spinning off private equity investments, these same firms are busily creating the next investment bubble on Wall Street -- this time focused on structured assets based upon corporate debt, Treasury bonds or nothing at all -- that is, pure derivatives," Whalen wrote.
The financial regulatory reform legislation known as the Dodd-Frank Act, signed by President Barack Obama on July 21, prohibits banks from engaging in proprietary trading and limits investments in private-equity funds. Individual investors, who "love the higher yields" on structured notes, will lose money when benchmark interest rates climb, according to Whalen. "We already know of two hedge funds that are being established specifically to buy this crap from distressed retail investors as and when rates start to rise," said Whalen, a former Federal Reserve Bank of New York official and co-founder of the Torrance, California-based research firm.
The Mother Of All Bubbles
by Jim Quinn - Burning Platform
In the latest issue of The Casey Report Bud Conrad does a fantastic job analyzing the truth about Asia. Japan is a ticking demographic time bomb. The Chinese government has created the mother of all bubbles and when it pops, it will be felt around the world. The China miracle is not really a miracle. It is a debt financed bubble. Sound familiar?
I picked out 4 charts from Bud’s article that paint the picture as clearly as possible. The chart below shows that compared to the real estate bubble in Japan during the late 1980s and the current bubble in China, the US housing bubble looks like a tiny speed bump. The US has 20% to 30% more downside to go. For those looking for a housing recovery, I’d like to point out that Japan’s housing market has fallen for 20 years with no recovery. I wonder if the National Association of Realtors will be running an advertisement campaign in 2025 telling us it is the best time to buy.
Take a gander at home prices in China. Since the 2008 financial crisis, the Chinese housing market has skyrocketed 60%. There are now 65 million vacant housing units. The question is no longer whether there is a Chinese housing bubble, but when will it pop. There is one thing that bubbles ALWAYS do. An that is POP!!!
The price of land in and around Beijing has gone up by a factor of 9 in the last few years. Delusion isn’t just for Americans anymore. These two charts should be placed next to the word “bubble” in the dictionary. This will surely end in tears for anyone who has bought a house in China in the last two years.
As Mr. Alan Greenspan can attest, bubbles can only form when monetary policy and/or fiscal policy is extremely loose. The bubble king supercharged the US housing bubble with his 1% interest rates in the early 2000s. The Chinese must have hundreds of Paul Krugman disciples running their economic bureaucracy. There can never be enough stimulus to satisfy a Krugmanite. The Chinese leaders feel they must keep their GDP growing at 10%. A slowing of growth to 5% would unleash social chaos among the hundreds of millions of peasants who have come to the cities from the countryside for jobs. The chart below shows that when you control the printing presses and the banks making the loans, you can make stimulus ”work”. In the U.S., the Federal Reserve has printed, but the banks have hoarded their cash and have not made loans.
The Chinese authorities have printed and instructed the banks to make loans for shopping malls, apartment buildings, office towers, and condo towers. Average citizens have bought as many as five condos. Every Wang, Chang, and Wong knows that real estate only goes up. Their $585 billion stimulus package was used to build entire cities that sit unoccupied. The 2.2 million square foot South China Mall, with room for 2,100 stores, sits completely vacant. The Chinese have taken the concept of “bridges to nowhere” to a new level.
Over a 20-month period, Chinese M2 grew 47%, reflecting the outrageous level of spending by the Chinese authorities. When you hand out $3.5 trillion to developers, they will develop. When a government official, who can have you executed, tells you to lend, obedient bankers lend. The Chinese authorities can hide the truth for a period of time, but the bad debt caused by the Chinese stimulus and malinvested in office buildings, condos, malls, and cities will eventually lead to a monumental collapse in the Chinese real estate market. This will result in a stock market crash and a dramatic slowing in economic growth.
The mother of all bubbles will Pop. Only the timing is in doubt. Based on history, the Chinese real estate bubble is in search of a pin.
'Breaking the Buck' Was Close for Many Money Funds
by Eleanor Laise - Wall Street Journal
At least 36 of the 100-largest U.S. prime money-market funds had to be propped up in order to survive the financial crisis, according to a report from Moody's Investors Service.
From August 2007 to December 2009, at least 20 firms that manage such funds in the U.S. and Europe pumped more than $12 billion combined into their funds, according to the Moody's Corp. unit. The lifelines included purchases of troubled securities and capital contributions. Without that help, the battered money-market funds would have "broken the buck," or fallen below the $1-a-share net asset value typically maintained by the funds, said Henry Shilling, senior vice president at Moody's.
Prime funds invest in securities issued by corporations, the government and government-sponsored enterprises such as Fannie Mae. The report shows how much the money-market world was rocked by the financial crisis. The chaos deepened in September 2008, when Reserve Primary fund's net-asset value dropped to 97 cents a share because of its holdings of battered Lehman Brothers Holdings Inc. debt. Investors pulled more than $200 billion from prime money-market funds over the next two days. U.S. officials created a temporary money-market guarantee to calm investors, who generally consider money-market funds as safe as cash.
Moody's warned that mutual-fund companies might be less willing to bail out troubled money-market funds next time. With rock-bottom interest rates putting severe pressure on management fees and profit margins, "there's a lot less at stake" for firms that decide not to rescue imperiled money-market funds, Mr. Shilling said. Some fund managers said the business remains attractive despite the low-interest-rate squeeze. "For most large managers, this is a very good business and has acceptable profit margins even in this market," said Robert Deutsch, head of the global liquidity business for J.P. Morgan Asset Management, a unit of J.P. Morgan Chase & Co. Most major money-fund managers "see the long-term opportunity."
New money-market fund regulations that recently began taking effect were designed to make such funds safer. But the rules also push the funds into a narrower pool of investment options, increasing the risk of a potential market disruption, said Mr. Shilling of Moody's. Other money-fund experts said the new rules impose restrictions that should reduce the need for future bailouts. "The willingness to bail funds out likely will be restricted or reduced in the future, but the necessity should be reduced as well," said Peter Crane, president of Crane Data LLC, which tracks money-market funds.
Student-Loan Debt Surpasses Credit Cards
by Mary Pilon - Wall Street Journal
Consumers now owe more on their student loans than their credit cards.Americans owe some $826.5 billion in revolving credit, according to June 2010 figures from the Federal Reserve. (Most of revolving credit is credit-card debt.) Student loans outstanding today — both federal and private — total some $829.785 billion, according to Mark Kantrowitz, publisher of FinAid.org and FastWeb.com.
"The growth in education debt outstanding is like cooking a lobster," Mr. Kantrowitz says. "The increase in total student debt occurs slowly but steadily, so by the time you notice that the water is boiling, you’re already cooked." By his math, there is $605.6 billion in federal student loans outstanding and $167.8 billion in private student loans outstanding. He estimates that $300 billion in federal student loan debts have been incurred in the last four years.
Partially, this is a story about Americans paying down credit card debt. Some are seeking a new frugality, but many credit card companies are raising minimum monthly payments or cutting off new and existing lines that consumers in the past may have turned to during tough times. Revolving credit, the majority of which is credit card debt, reached a high in September 2008 of $975.7 billion, according to Fed data. A consumer who juggles both credit-card and student-loan debt is likely to pay of the credit-card first, as that debt tends to carry a higher interest rate.
In terms of volume, a person is likely to borrow more money to go to school today than, say, spend on necessities using a credit card during a patch of unemployment. Tuition at public and private four-year universities last year went as high as $26,000, with additional fees for housing and books not showing any signs of letting up either. It’s no surprise that many parents, reeling from the downturn, would turn to borrowing to make up the difference. With the cost of education increasing rapidly and the duration of unemployment increasing, perhaps the surprise is that this turning point didn’t hit earlier.
Student Loan Justice, a Washington State-based student loan advocacy group issued a statement on the student-loan eclipse, estimating that media coverage of credit cards exceeds coverage of student loans "by a factor of approximately 15-to-1 based on unscientific news surveys conducted since 2007." But student loan debt, in many ways, is different than credit-card debt. These loans typically can’t be discharged in bankruptcy. They have different repayment terms, some of which can catch some have heavy consequences for borrowers who miss payments and borrowers’ families.
Flexible Forecasting: Looking For The Next Economic Model
by Bill Watkins - New Geography
Last autumn I gave a talk in California's San Fernando Valley. I was the last of three economists speaking that day, and I watched the other economists’ presentations, each a rosy forecast of recovery and imminent prosperity. So, I was a bit nervous when it was my turn to speak, because I had a forecast of extended malaise. People don’t like to hear bad news, and they do blame the messenger. In the end, I was relieved. No tomatoes, no catcalls.
That’s how things went last fall and winter. Many economists confidently predicted a rapid recovery, while my group’s forecasts were pretty dismal: weak economic growth with little if any job creation. Today, many of those same economists’ forecasts are far closer to ours. Why? Part of the problem is the fact that macroeconomics is an unsettled discipline. We have lots of macroeconomic models, none of which is adequate for all states of the world all the time. Each provides insight, but no single model can cope with the awesome complexity of the world. A large part of the art of forecasting is determining which model is most applicable to the current situation; which ones include insights that are dominant today.
The problem is exacerbated when economists become excessively committed to a particular model. This isn’t religion or politics, it's forecasting. It is hard enough. There is no reason to handicap yourself by excessive fealty to some model or doctrine. There was another problem that resulted in the change of tune. The world changed in September 2008. We call it a regime shift. It's a move from one (good) equilibrium to another (bad) equilibrium. Statistical models that worked well in the old regime don’t work in the new regime. We hustled to adjust our models, but admitted that with limited experience in the new regime, we were less confident in our forecasts.
The problem with a regime shift is that it is similar to a change in the rules of a game. Old relationships don’t hold anymore. Football is an example: If you changed the rules to allow five downs instead of four, nobody would predict punts on fourth down. Some economists didn’t recognize the regime shift. They went about their business using the same old models in a new world. Comments about the length of a typical recession or about how sharp declines are followed by rapid recoveries were clear signals that the speaker didn’t understand the situation.
Some economists were fooled by the stimulus. The rules of accounting cause government spending to be reflected as an increase in economic activity. Stimulus plans such as Cash for Clunkers and tax credits for home purchases moved the timing of transactions, artificially reinforcing the direct spending impacts. Similarly, bailouts and foreclosure prevention programs postponed the recognition of losses.
Many interpreted the resulting increase in last winter’s reported activity as permanent, but that could not be. We were not building anything or laying the groundwork for sustained prosperity. Instead, we were just continuing the previous decade’s consumption binge. The banks had failed, but the government had stepped in. It became the mother of all banks, borrowing from future citizens and other countries to fuel today’s consumption.
Regime shifts that lead to a bad equilibrium appear to be similar to bank runs. There need be no basis for panic, but a panic can guarantee the demise of a bank. The result of a panic on a bank ends there. The bank is failed, gone. There may or may not be a contagion effect on another bank. A panic can also guarantee an economic decline. But our economy is different than a bank. It can’t fail, in the sense that we can’t shut it down and walk away. We’re all still here after a regime shift. We’re stuck with a mess.
We did have a mess after September 2008. All of a sudden, everyone’s wealth had declined, a lot. Businesses, consumers and governments were over-leveraged. Risk aversion had increased, perhaps to remain high for decades. Our understanding of economic risks had changed. We had discovered black swans – rare and unexpected outliers — in our system.
The problem with regime shifts is that we don’t know how to initiate or cause them. We see shifts to bad regimes, and we can see their self-fulfilling nature. Can there be some self-fulfilling process that leads to a shift to a better regime? I hoped so, and I hoped that Obama’s election would initiate such an event. Our forecasts aren’t based on hope though, and it’s just as well that we didn’t forecast that his election would generate a spontaneous recovery.
Today, enough time has passed that even the most slowly adapting forecasters are forced to confront the post-2008 data and the government’s failed economic efforts. As forecasters confront these facts, their forecasts are becoming increasingly gloomy. Now, forecasts of protracted malaise or even a double-dip recession are increasingly common. Why? Because we borrowed to extend a consumption binge, and we compounded that error with omissions and perverse policy.
The stimulus’s omissions are glaring. We didn’t significantly invest in infrastructure that would improve our future growth. We failed to address the weaknesses in our education sector that fuel increasing inequality, sentence many to a life of hopelessness, and permanently constrain our economic growth. We did nothing to encourage small business’s growth; in an example of perverse policy, we are actually creating a new regulatory regime that favors large companies.
Then there were the actions that will probably restrain future economic growth. The minimum wage was raised. We had health care reform, but we didn’t address the real problem: the fact that the health care consumer pays an insignificant portion of the bill at the time of consumption. We had financial reform that failed to address the fundamental problems of too-big-to-fail, and we protected risky activities, increasing the regulatory burden and crippling the ability of small banks. We halted much of our offshore drilling.
Looking forward, there is little reason for optimism. We’re considering huge increases in our energy costs through greenhouse gas regulation. We have a massive tax increase scheduled at the end of the year. While a double-dip recession is not the most likely outcome, we can’t reject the possibility. More likely, we face a long slow struggle to overcome ourselves and restore real prosperity. The forecasters’ consensus appears to be moving toward accepting that reality.
Governments Go to Extremes as the Downturn Wears On
by Michael Cooper - New York Times
Plenty of businesses and governments furloughed workers this year, but Hawaii went further — it furloughed its schoolchildren. Public schools across the state closed on 17 Fridays during the past school year to save money, giving students the shortest academic year in the nation and sending working parents scrambling to find care for them. Many transit systems have cut service to make ends meet, but Clayton County, Ga., a suburb of Atlanta, decided to cut all the way, and shut down its entire public bus system. Its last buses ran on March 31, stranding 8,400 daily riders.
Even public safety has not been immune to the budget ax. In Colorado Springs, the downturn will be remembered, quite literally, as a dark age: the city switched off a third of its 24,512 streetlights to save money on electricity, while trimming its police force and auctioning off its police helicopters. Faced with the steepest and longest decline in tax collections on record, state, county and city governments have resorted to major life-changing cuts in core services like education, transportation and public safety that, not too long ago, would have been unthinkable. And services in many areas could get worse before they get better.
The length of the downturn means that many places have used up all their budget gimmicks, cut services, raised taxes, spent their stimulus money — and remained in the hole. Even with Congress set to approve extra stimulus aid, some analysts say states are still facing huge shortfalls. Cities and states are notorious for crying wolf around budget time, and for issuing dire warnings about draconian cuts that never seem to materialize. But the Great Recession has been different. Around the country, there have already been drastic cuts in core services like education, transportation and public safety, and there are likely to be more before the downturn ends. The cuts that have disrupted lives in Hawaii, Georgia and Colorado may be extreme, but they reflect the kinds of cuts being made nationwide, disrupting the lives of millions of people in ways large and small.
Education: Hawaii Furloughs Its Children
MILILANI, Hawaii — It was a Friday, and Maria Marte, an administrator for an online college that caters to members of the military, should have been at her office at a nearby Army hospital. Her daughters, Nira, 11, and Sonia, 9, should have been in school. Instead, Ms. Marte was sitting with a laptop in the dining room of her home in this neatly manicured suburb of Honolulu. "Did you already send your registration in?" she asked a client on the phone, trying to speak above the peals of laughter coming from the backyard, where the girls were having a water-balloon fight with some friends.
It was the 17th, and last, Furlough Friday of the year, the end of a cost-cutting experiment that closed schools across the state, outraging parents and throwing a wrench into that most delicate of balances for families with children: the weekly routine "I have to pay attention to the customers, and make sure that I’m understanding what they need," said Ms. Marte, 37, whose husband, Odalis, an Army major, had been deployed in Afghanistan for nearly a year. Then she nodded at the window, toward the girls. "But at the same time, I have to make sure that they’re not killing each other."
For those 17 Fridays, parents reluctantly worked from home or used up vacation and sick days. Others enlisted the help of grandparents. Many paid $25 to $50 per child each week for the new child care programs that had sprung up. Children, meanwhile, adjusted to a new reality of T.G.I.T. Getting them up for school on Mondays grew harder. Fridays were filled with trips to pools and beaches, hours of television and Wii, long stretches alone for older children, and, occasionally, successful attempts to get them to do their homework early.
But if three-day-weekends in Hawaii sound appealing in theory, many children said that they wound up missing school. "I’m really not a big fan of furloughs," said Nira Marte, a fifth grader, explaining that she missed the time with her friends and her teacher. Four-day weeks have been used by a small number of rural school districts in the United States, especially since the oil shortage of the 1970s. During the current downturn, their ranks have swelled to more than 120 districts, and more are weighing the change.
But Hawaii is an extreme case. It shut schools not only in rural areas but also in high-rise neighborhoods in Honolulu. Suffering from steep declines in tourism and construction, and owing billions of dollars to a pension system that has only 68.8 percent of the money it needs to cover its promises to state workers, Hawaii instituted the furloughs even after getting $110 million in stimulus money for schools. Unlike most districts with four-day weeks, Hawaii did not lengthen the hours of its remaining school days: its 163-day school year was the shortest in the nation.
The furloughs were originally supposed to last two years, but the outcry was so great — some parents were arrested staging sit-ins at the office of Gov. Linda Lingle, a Republican — that a deal was hammered out to restore the days next year. On the last furlough day, Ms. Marte toggled back and forth between her girls — making them pizza, taking them to swim practice — and a stream of e-mails and calls. At one point, a soldier on the mainland was interrupted when his baby started bawling. "Don’t worry, that’s fine," Ms. Marte reassured him. "I’m in the same boat."
Transportation: A County Shuts Its Bus System
RIVERDALE, Ga. — Kelly Smith was reading a library copy of "The Politician," the tell-all about John Edwards, as his public bus rumbled through a suburb of Atlanta. It was heading toward the airport, where he could switch to a train to his job downtown, in the finance department of the Atlanta Public Schools system. But his mind was drifting. It was March 31, the last day of public bus service. Clayton County had decided to balance its budget by shutting down C-Tran, the bus system, stranding 8,400 daily riders. Mr. Smith, 45, like two-thirds of the riders, had no car. He needed a plan. "I think that what they’re doing is criminal," Mr. Smith said as his 504 bus filled up. "I’ll figure something out, but I see a lot of people here who don’t have an out."
The next morning, this is what he had figured out: a state-run express bus stopped around three miles from his apartment in Riverdale. So Mr. Smith rose at 5, walked past the defunct C-Tran bus stop just outside his apartment complex and hiked the miles of dark, deserted streets, many of which had no sidewalks. "If I get hit by a car, it’s my fault," he said as he crossed a highway. "Who wants to start their day off like this? This is why I don’t get up and jog." Mr. Smith was determined to get to the job he had landed in November, and to get there on time. "I was out of work for two and half years, with the economic crisis," he said. "So the last thing I want to do is walk away from a job."
Around the country, public transportation has taken a beating during the downturn. Fares typically cover less than half the cost of each ride, and the state and local taxes that most systems depend on have been plummeting. In most places, that has meant longer waits for more crowded, dirtier and more expensive trains and buses. But it meant the end of the line in Clayton County, a struggling suburb south of Atlanta where "Gone With the Wind" was set and which is now home to most of Hartsfield-Jackson Atlanta International Airport. The county — hit hard by the subprime mortgage crisis and the wave of foreclosures that followed — decided it could no longer afford spending roughly $8 million a year on its bus system, which started in 2001. It hoped that some other entity — like the state — would pick up the cost.
If the threat to shut the system down was a game of chicken, no one blinked. Now all five bus routes are gone, and riders are trying to adjust. Jennifer McDaniel, a hostess at a Chili’s in the airport, was forced to spend her tax refund, and take out a big loan, to buy a car. Jaime Tejada, 36, a Delta flight attendant, wondered why transit was so much better in the countries he flies to. And Tierra Clark, 19, who studies dental hygiene and works five nights a week at the Au Bon Pain at the airport, was left with an unwanted new expense. "I’ll have to call a taxi from now on — $13.75 every night," Ms. Clark said, as she rode the very last C-Tran bus home.
Now there is talk of levying a new sales tax so the county can join the Metropolitan Atlanta Rapid Transit Authority, which it voted not to join when it was created nearly four decades ago. That could get the buses up and running again. Even if that happens, though, it could be years off — too late for Mr. Smith. After spending a carless Easter vacation trying to figure out a better way to get to work, or even to get his groceries, he ended up quitting his first job in two and a half years and moving just outside Dallas, where his girlfriend had landed a job with a bank. "A lot of people are leaving Riverdale," he said.
Public Safety: Lights Out In Colorado Springs
COLORADO SPRINGS — It was when the street lights went out, Diane Cunningham said, that the trouble started. Her tires were slashed, she said. Her car was broken into. Strange men showed up on her porch. Her neighborhood had grown deserted at night, ever since four streetlights in a row were put out on Airport Road, the street outside her mobile home park. That is why Ms. Cunningham, 41, and her son Jonathan, 22, were carrying a flat-screen television out of their mobile home on a recent afternoon. "I’m going to pawn this," Ms. Cunningham said, "to get a shotgun."
It is impossible to say whether the darkness had contributed to any of the events that frightened the Cunninghams. But ever since Colorado Springs shut off a third of its 24,512 streetlights this winter to save $1.2 million on electricity — while reducing the size of its police force — many residents have said that they feel less safe. A few miles down Airport Road a 62-year-old man, Esteban Garcia, was shot to death in April when he was robbed outside his family’s taqueria and grocery in a parking lot that had lost the illumination of its nearest streetlight. Gaspar Martinez, a neighboring shopkeeper, said that he believed the lack of the light was partly to blame.
"You figure the robbers think that if it’s dark, it’s the best time to hit," said Mr. Martinez, 34, whose store, Ruskin Liquor, is in the same small strip mall. Mr. Martinez said that he put more lights up outside his store after the shooting. The police, who arrested several suspects, said that there was no indication that the doused light had played a role in the crime — or, indeed, in any crimes in Colorado Springs, which remains safer than most cities of its size. But this might be a case, they said, where perception is as important as reality.
"All the sociologists have said this for years: what matters to people isn’t really the number of reported crimes, it’s their perception of safety," said the city’s police chief, Richard W. Myers. "And let’s say we don’t see any bump in crime — that would be a good thing. But people don’t feel as safe. They’re already telling us that, even if the numbers don’t bear that out. So do we have a problem? I think so." Chief Myers said he worried that if law-abiding citizens stopped going out at night or visiting parks, the city’s deserted open spaces could attract more criminals.
One of most influential policing concepts in recent years has been the "broken windows" theory, which holds that addressing minor crimes and signs of disorder can head off bigger problems down the road. Colorado Springs is taking a different tack. To close a budget gap — the city’s voters, many of whom favor smaller government, turned down a property tax increase in November, and a taxpayer’s bill of rights makes it hard for city officials to raise taxes — Colorado Springs has stopped collecting trash in its parks, stopped watering many medians on its roads and reduced its police force.
The sprawling city of roughly 400,000 at the foot of Pike’s Peak — which covers 194 square miles — made national news when it auctioned off its police helicopters. But less-heralded police cuts could have more impact: the force, which had 687 officers two years ago, is down to 643 and dropping. At any given time, the department estimates that there is a 23 percent chance that all units will be busy. So it has reduced the number of detectives who investigate property crimes, cut the number of officers assigned to the schools and eliminated units that tracked juvenile offenders and caught fugitives. Officers no longer respond to the scene of most burglaries, at least if they are not in progress.
At the same time, the city joined others — from Fitchburg, Mass., to Santa Rosa, Calif., and began turning off streetlights. Several recent studies have suggested that streetlights help reduce crime — something residents here say is obvious. Natalie Bartling, a new mother, could not believe it when the light outside her home was shut off in April. Ms. Bartling, 38, had successfully lobbied for the light five years ago after a wave of vandalism and petty thefts hit her middle-class block. So this time she called daily until the city agreed to turn it back on. "When it got shut off, it was like missing something," she said on a recent night, standing under its glow. "Part of your life."
Muni market offers opportunities despite budget woes
by Aaron Pressman and Lauren Young - Reuters
Despite the financial troubles of states and municipalities across the United States, financial advisers and mutual fund managers agree that the risk of wholesale municipal bond defaults is minuscule. In fact, new buyers are stepping in to take advantage of enticing bond yields. "We do have some problems out there, but not anywhere as significant as some have portrayed," said Thomas Metzold, co-head of municipal investing at money manager Eaton Vance Corp (EV.N) in Boston. "Professional investors aren't selling bonds. We know it's overstated." With tax revenues down dramatically from a few years ago, states, municipalities, and school districts are slashing budgets by laying off teachers and firefighters, closing libraries and canceling road repairs. But almost none of them are so strapped for cash that they have stopped paying interest on their debt.
The state of California gets most of the attention, with its gaping $19 billion budget deficit and lack of a final budget more than a month into the new fiscal year. But California's recent debt issues have been well-received by institutional buyers. It also offers some of the biggest opportunities to income-hungry individual investors. For an in-state resident in the highest state and federal tax brackets, the after-tax equivalent yield on California's 30-year general obligation bonds can top 8.5 percent. The high yields relative to Treasuries have attracted some unusual buyers that are not even interested in tax-free interest. At money manager Franklin Resources Inc (BEN.N), not just muni funds are buying California debt. It has also attracted a rare cross-over buy from the massive $53 billion Franklin Income Fund, which typically buys only taxable bonds, said Rafael Costas, co-director of the firm's muni department.
"The risk of not getting paid is so infinitesimal," Costas said, noting that the state continues to easily cover its debt obligations. Still, investors looking at individual bonds should shop carefully in the current tax-exempt market to avoid problems, financial advisers say. Savvy shoppers may find some bargains as well. One of the safest sectors within the muni market includes bonds backed by water and sewer fees, advisers say. Most people continue to pay their water bills, even when they lose their jobs. And water authorities tend to have far more cash flow than they need to meet their debt obligations. "Our favorites are sewer bonds. Even in a difficult economic time, folks still need to flush their toilets," said Lynn Ballou, a financial adviser at Ballou Plum Wealth Advisors in Lafayette, California.
Many bonds backing important municipal facilities like airports and hospitals are also a good bet, says Richard Ciccarone, who heads municipal bond research at McDonnell Investments in Oak Brook, Illinois. Ciccarone cites 20-year bonds backed by San Francisco's airport that yield 5.40 percent. Some advisers suggest that individual investors stick to more diversified funds instead of selecting their own portfolio. "I'd much rather trust the credit analysis of experienced bond managers rather than rely on my own research," said adviser Cliff Caplan, president of Neponset Valley Financial Planners in Norwood, Massachusetts. Investors seem to agree. They've been pouring money into municipal bond funds. Thanks to inflows, along with strong market performance, municipal funds had record assets under management of $343 billion for the week ended August 4. One year ago, municipal bond funds had total assets of $254 billion.
Among mutual funds, Caplan prefers offerings from Legg Mason Inc's (LM.N) Western Asset unit, Eaton Vance, Thornburg and Deutsche Bank's DWS line of funds. Jerry Paul, chief investment officer at Essential Investment Partners LLC in Denver, says investors can take advantage of market inefficiencies in closed-end muni funds. Closed-end funds issue a fixed number of shares and trade on an exchange. That means the share price can get out of whack with the value of a fund's underlying holdings, creating a bargain opportunity. One short-term play that Paul is buying is the BlackRock California Investment Quality Municipal Trust (RAA.P). The fund is trading at a discount to the value of its holdings and yields over 5 percent tax free. But holders will vote on liquidating the fund next month, which could cause the share price to rise and eliminate the discount. "The California risk is reduced by the high likelihood of liquidation over the next few months, which gives us a chance to review the situation," Paul said.
Lehman, HSBC May Be Sued Over Worthless ‘Minibonds’
by Bob Van Voris - Bloomberg
Lehman Brothers Holdings Inc. and HSBC Holdings Plcmay be sued over $1.6 billion in worthless securities sold to retail investors, primarily in Hong Kong, a judge in New York ruled. U.S. District Judge William H. Pauley III today reversed part of a decision by Lehman’s bankruptcy judge, who threw out a suit by seven holders ofstructured financial notes called minibonds. The plaintiffs seek to represent a class of investors in the notes from June 16, 2003, to Sept. 15, 2008, Pauley said in his decision. Pacific International Finance Ltd. issued the minibonds and marketed them as linked to the credit of financially sound companies and backed by AAA-rated collateral, Pauley said. The minibonds became worthless as a result of the collapse of Lehman Brothers, which filed the biggest bankruptcy in U.S. history in September 2008.
A Hong Kong regulatory authority investigation disclosed that Lehman designed the minibonds program and used Pacific Finance to issue them, Pauley said. Lehman selected HSBC Bank USA as trustee of the collateral securing the notes, Pauley said, citing testimony in the Hong Kong proceeding. In two orders, issued in November and December, U.S. Bankruptcy JudgeJames Peck ruled that the plaintiffs lacked standing to sue and that any attempt to revise their complaint would be futile. In today’s ruling, Pauley reversed the dismissal of one count against HSBC and Lehman and permitted the plaintiffs to amend two dismissed counts. Neil Brazil, an HSBC spokesman, said the firm had no immediate comment on the ruling. Kimberly Macleod, a Lehman spokeswoman, didn’t return a voice-mail message seeking comment. The case is Wong v. HSBC USA Inc., 10-cv-00017, U.S. District Court, Southern District of New York (Manhattan).
Corporate "cash on the sidelines"
by John Hussman - Hussman Funds
Four years ago, in There's No Such Thing as Idle Cash on the Sidelines, I observed:
"Investors should not believe that the "cash on the balance sheets" of corporations might suddenly be used, in aggregate, for new investments and capital spending. That cash on their balance sheets has already been deployed as loans to the Federal government and to other companies. Now, yes, if the government runs a surplus and retires its debt, in aggregate, or the other companies that borrowed the money generate new earnings and then pay off their debt, in aggregate, then those new savings that retire the T-bills and commercial paper then make it possible for the recipients to finance new investment, in aggregate. So as usual, savings equals investment, and new savings can finance new investment. But what investors often point to and call "cash on the sidelines" is really saving that has already been deployed and used either to offset the dissavings of government or to finance investments made by other companies. Once those savings have been spent, you can't, in aggregate, use the IOUs (in the form of money market securities) to do it again."
Now, as then, analysts are pointing to an apparent pile of corporate "cash on the sidelines" as if these holdings of debt securities somehow make new corporate spending more likely. In order to evaluate this argument, it's necessary to understand that what is being called cash is actually a stack of IOUs for money that has generally already been spent by other companies or by the government.
Don't get me wrong. At an individual company level, it's obvious that if DuPont has a bunch of marketable securities on its balance sheet, it is free to sell those securities and spend the money on new equipment and so forth. The issue is that somebody else has to buy those securities. At the end of the day, there is no less "cash on the sidelines" after that change of ownership than there was before.
Put simply, there is a lot of apparent "cash on the sidelines" because the government and many corporations have issued enormous quantities of new debt, often with short maturities, while other corporations have purchased it. It is an equilibrium. The assets that are held in the right hand represent debt that is owed by the left. You cannot call that pile of short-term marketable securities an asset without calling it a liability. The cash on the sidelines is evidence of debt incurred to fund economic activity that is already in the past. It will remain "on the sidelines" until the debt is retired. The government debt has been issued to finance deficit spending. At the same time, a great deal of corporate debt has been issued over the past year apparently as a pre-emptive measure against the possibility of the capital markets freezing up again.
What's fascinating about the "corporate cash" argument is that few observers recognize that a great deal of this cash is not retained earnings but new debt issuance. Brett Arends of MarketWatch puts present levels of corporate cash in perspective: "According to the Federal Reserve, nonfinancial firms borrowed another $289 billion in the first quarter, taking their total domestic debts to $7.2 trillion, the highest level ever. That's up by $1.1 trillion since the first quarter of 2007; it's twice the level seen in the late 1990s. Central bank and Commerce Department data reveal that gross domestic debts of nonfinancial corporations now amount to 50% of GDP."
Andrew Smithers observes that the prevailing corporate debt burdens, " un derline the poor state of the U.S. private sector's balance sheets. While this is generally recognized for households, it is often denied with regard to corporations. These denials are without merit and depend on looking at cash assets and ignoring liabilities."
Similarly, Annaly Capital notes " in relation to their debt outstanding, corporations are less liquid than they were prior to the recession" (HT: The Pragmatic Capitalist / Business Insider)
As with job creation, new investment is not driven by the amount of cash on hand, but by anticipation of profitable activity and fear of excessive demand that exceeds capacity. There is little evidence that these considerations are powerful at the present time.
The Rise of the Permabears: Economic Pessimists Gain Cachet
by Landon Thomas Jr. - New York Times
The central question dividing economists these days is whether Western governments should spend more to ward off a potential second recession or retrench to hold down their ballooning debts to restore confidence among investors.
But Albert Edwards, an investment strategist in London for the French bank Société Générale, considers the debate a waste of time. To be specific, he forecasts a "bloody, deep recession" that produces a stock market collapse of at least 60 percent, followed by years of inflation of 20 percent to 30 percent as the persistent printing of money by central banks desperate to improve the situation sends prices soaring. Mr. Edwards’s sandals and chuckling demeanor belie his reputation as perhaps the City of London’s best-known permabear — a species that has long flourished on the outer margins of the financial industry but rarely inside mainstream banks. That is no longer true.
With the shocking financial crisis of 2008 still fresh in people’s minds, and gloom-spinning economists like Nouriel Roubini having achieved pop culture status, even longstanding pessimists like Mr. Edwards — who has been forecasting a Japanese-style stock market slump in the United States since 1997 — are being treated with newfound respect. In many smart-money circles, listening to bears has become fashionable, especially now that doubts remain about the sustainability of the euro zone, concerns grow that the United States may slip back into recession and that even the Chinese growth engine may seize up. But to some, the popularization of extremely dire forecasts suggests that the pendulum may have swung too far.
"Nothing is ridiculous anymore," said Philippe Jabre, a hedge fund executive in Geneva. "There is no doubt that these days extremely negative research is being tolerated more." Mr. Jabre said that most of the research that came his way had a distinctly negative bias and that finding actionable ideas with a positive spin was becoming far more difficult. "These guys are reinforcing a conviction among many who invest in hedge funds that they should remain scared," he said. Mr. Edwards’s newfound popularity reflects the trend. Once frequently shown the door by disbelieving clients, Mr. Edwards recently drew 600 investors to a conference in London.
Similarly, Bob Janjuah, the one strategist in London whose prognostications are seen by some as even more dire than those of Mr. Edwards — "even I get depressed reading his stuff," Mr. Edwards remarked — said he was courted by half a dozen investment banks this summer before deciding to leave his post at Royal Bank of Scotland to join Nomura. (He starts officially in October.) "Clients are more receptive to hearing polar ends of an investment view," said Mr. Janjuah, who expects economic growth for the top developed economies to average little better than 1 percent a year over the next five years.
Further afield, Raoul Pal, a former Goldman Sachs derivatives expert and hedge fund manager, has attracted a growing following with his monthly research note that, most recently, predicted a depression in the United States similar to that of the 1930s and eventual bankruptcy for Britain. Mr. Pal writes The Global Macro Investor from a holiday village in Valencia. a province in Spain. He said that demand was so great now that he has the luxury of doling out his high-price annual subscriptions only to clients he considers sophisticated enough to pass muster or who come recommended by people he trusts. Others must join a waiting list, Mr. Pal said, although he declined to say how large the group is.
He said that 30 percent of his clientele — which includes pension and hedge funds, governments and proprietary traders at banks — consisted of wealthy family offices with assets of more than $200 million. "They are easily the most bearish of my subscribers because they invest in the longer term," he said, "and in the longer run they see more uncertainty than ever before."
According to TrimTabs, a funds researcher, hedge funds withdrew $3.5 billion in April and industry consultants say that many funds — positioned in July for a continuum of bad market news — were caught by surprise when the market rallied. "Where is the research telling me how good Intel’s earnings were going to be?" Mr. Jabre said. "I just have not seen it." In fact, if investors had been following the advice of Mr. Edwards or Mr. Pal over the last month as stocks have bounced back, they would have lost money, as both men readily acknowledge. Mr. Edwards has advised investors to be heavily underinvested in all equities, and Mr. Pal is betting against the United States stock market as well as shorting the euro.
Mr. Pal’s bad run began when, after becoming bearish in 2007 and reaping the fruits in 2008, he was caught short by the powerful recovery that began in March 2009. To date in his model portfolio, he has lost 96 percent on a short bet of the Indian stock exchange, 68 percent betting against the Chinese H share stock market and 68 percent on the American mutual fund company Franklin Templeton. (Until 2009, he says his model portfolio was up 700 percent.)
In the tradition of the great macro hedge fund investors like George Soros and Julian H. Robertson Jr., Mr. Pal, whose last job was as a portfolio manager at GLG, a hedge fund based in London, likes to pick a theme that may take years to pan out and run with it. His big bet is that the United States economy is not just about to enter a double-dip recession but that it will be far worse than anything experienced in the lifetime of anyone younger than 70.
He points to a weak rebound in consumer and industrial spending from the 2008 plunge, suggesting that companies and people will remain reluctant to borrow and spend. "Never before have we entered a recession with 10 percent unemployment," he wrote in his August report. "And if you take into account that on average a recession increases unemployment by 3 to 5 percent, we could see 15 percent unemployment in the U.S. — that is staggering."
As for whether central banks can rescue their economies through a fresh round of money injection, both Mr. Pal and Mr. Edwards are skeptical. They contend that there is no evidence that the huge injections of liquidity already engineered by the Federal Reserve, the European Central Bank and the Bank of England have led to a pickup in demand for loans.
That may be so. But Ed Yardeni, an independent strategist in the United States recognized for his consistently optimistic views, says it would be a mistake to bet against the evidence from strong corporate profits, which he thinks are already driving a global rebound. "Despite all this negative spin, we have seen one of the best corporate recoveries ever," he said. Executives at large companies "are being fed this same diet of pessimism, but instead of shutting down they are growing their profits and expanding their operations."
London City bonuses jump 25% to £10 billion
by Jonathan Sibun and Harry Wilson - Telegraph
City bonuses jumped by 25pc to £10bn in the latest pay round despite Government efforts to rein back bankers' pay in the aftermath of the financial crisis.
Financial sector bonuses paid out to the lucky few in the five-month period between December and April for the previous financial year reached £10bn, compared with £8bn in 2008, according to figures from the Office for National Statistics (ONS). The figures are likely to inflame the debate over banking industry pay at a time when banks are under fire for not doing enough to support the UK economy.
Lord Oakeshott, Liberal Democrat Treasury spokesman, said: "It's bonuses for bankers and cuts and cutbacks for everyone else. "The real tragedy is that bankers are helping themselves to bonuses at a time when many small businesses and first-time home buyers can't get a loan."
Last week, Britain's five largest banks reported financial results that showed they had made combined pre-tax profits of £15bn in the first six months of the year. The return to profitability of the banks, with Royal Bank of Scotland making its first profit since 2007, has increased the pressure on banks to increase their lending to small and medium- sized businesses, many of which complain they are having loan applications turned down.
Angela Knight, chief executive of the British Bankers' Association (BBA), said: "Bank bonuses in the UK are subject to more stringent government control than anywhere else in the world - and are taxed accordingly. "Banking and financial services are major employers, which is reflected in the overall pay bill. We all know that large bonuses are paid to only a small percentage of highly internationally mobile staff."
In a Mansion House speech last month Mark Hoban, Financial Secretary to the Treasury, told an audience of BBA delegates that the industry's remuneration system required reform. "I don't need to tell you that the next bonus round will be conducted against a background of continued pressure in the private sector," he said, adding that the Financial Services Authority would be reviewing its pay code.
Financial sector bonuses in the latest period were 39pc higher than at the start of the decade, according to the ONS, with £3.9bn being paid out in February alone. The results also show that UK banks are continuing to put aside billions of pounds to pay bonuses to staff working in their investment banking arms. Barclays said last week it had hived off £1.7bn for bonuses so far this year, the majority of which will go to staff at Barclays Capital, the bank's investment banking division.
Despite the large bonuses paid to investment bankers, British banks complain that the new rules on employee remuneration could put them at a marked disadvantage against international competitors.
Stephen Hester, chief executive of RBS, said the bank was struggling to retain some of the best employees in its Global Banking and Market (GBM) division, which houses its investment banking operations. Mr Hester said staff numbers in GBM were down partly as a result of the bank's inability to be able to pay the amounts required to lure the type of people it wants to hire.
Peter Sands, chief executive of Standard Chartered, made a similar complaint, warning that the case for the bank basing itself in London had "weakened" in the last year as a result of new rules on pay. Ms Knight said: "While the industry seeks to reward success and to discourage foolhardy risk-taking, key staff need to be rewarded or our competitors will snap them up." Lord Oakeshott had little time for these arguments and said he hoped the new independent commission on the banking industry would get to grips with the issue of pay. "Competition and market discipline seem to have broken down in the banking sector," he said.