The Automatic Earth

November 24 2009: Bonds, herds and game theory

2009-11-24T00:01:00.000-05:00

Detroit Publishing Co. Pulp 1890
Girls of the paper mills, taking a water break. Appleton, Wisconsin

Ilargi: Yes, existing home sales were up. But between the effect of last-ditch efforts (before it was extended) to get the $8000 tax credit, falling prices and most of all the ongoing subprime-condition FHA loans and the Fed's securities purchases, is the rise such a surprise? It may lift Wall Street for a bit, but, as Calculated Risk pointed out a few days ago, existing home sales are irrelevant for the economy. Inventory remains sky-high, and that's just the homes that are actually counted. All in all, not very interesting territory, if you ask me.

What I find far more intriguing to see, via Business Insider, is a paper by Jeff Saut at Raymond James. Saut argues that even if there is a bubble in stocks,

"under-invested institutional portfolio managers have to buy stocks into year-end driven by their under-performance, their subsequent "bonus risk", and ultimately their "job risk."

He links this to game theory, and quotes Jeremy Grantham, who says:

"In markets where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone’s ultimate job description becomes ‘keep your job!’ (Manifestly) Career risk-reduction takes precedence over maximizing the client’s return.

Efficient career-risk management means never being wrong on your own, so herding, perhaps for different reasons, also characterizes professional investing. Herding produces momentum in prices, pushing them further away from fair value as people buy because they are buying."

Now, I find the connection between game theory and economics a very shaky one, even if, or should I say because, 8 Nobel Fakeconomics winners were game theorists. The problem with the connection is that things like perfect rationality, perfect information availability and perfect choices among players are presumed and even taken for granted. Which, you are right, sounds an awful lot like classical economics. Of course we've long known that such presumptions are ridiculous, and that makes game theory on the whole a lousy fit with a field such as economics. What is at the heart of this are game theory solution concepts such as the Nash equilibrium:

A set of strategies is a Nash equilibrium if each represents a best response to the other strategies. So, if all the players are playing the strategies in a Nash equilibrium, they have no unilateral incentive to deviate, since their strategy is the best they can do given what others are doing. (Wiki)

I hope the idea is clear.

Still, the underlying notion Saut introduces is, as I said, intriguing. Just about everyone who follows the economy even a little is wondering why stock markets are rising while the economies they are supposed to reflect are scraping their respective gutters ever deeper? Grantham again:

"Refusing, on value principal, to buy in a bubble will, in contrast, look dangerously eccentric. And when your timing is wrong, which is inevitable sooner or later, you will in Keynes’ words – ‘Not receive much mercy’" [..] "Today the challenge is not getting the big bets right. It’s arriving back at trend with the same clients you left with . . ."

In other words, there are scores of large investors out there who are willing to put their clients’ money in what they realize, to an extent, are potentially losing or even bad bets. Going against the ruling trends, say Saut and Grantham, would be -perceived as- riskier than following one's instincts, and even than one's desire to maximize profits for clients. And that is quite a statement. Better to lose with everyone else than to lose alone. Not exactly an attitude that will make you rich, but yes, it might keep you in a job for a while.

Where it gets really good is when we ponder how many of these investors think the risk of losing is over 50%, and then still keep doing what they do. Psychological theories about herding behavior may well prove to be much more useful in understanding this phenomenon than game theory. After all, game theory doesn't seem to cover behavior that doesn't seek optimum returns.

I would add that perhaps there is an additional factor at play. Many of these institutional investors have lost fortunes for their funds last year, and until March 2009. The urgent desire to make up as much of these losses as possible may also tempt them to arrive at irrational risks and decisions. And yes, that may also be because they fear losing their jobs.

There is of course a flipside to all this. One which we all instinctively recognize. We know this can't go on forever. Somewhere down this upward line something will happen that will break the herd. Ever seen a herd panic? I know many of you think the current trend has a lot of life left in it, but herds are inherently unpredictable.

To see how this might work out, it seems reasonable to ask: what are these "game theory driven" investors buying into? We've sufficiently covered the made up and embellished number games from governments and media that accompany the market rally. Which may have outlived itself.

Today brings a veritable avalanche on sovereign debt. And hey, maybe that will do it.

As for US debt, the New York Times reports:

Treasury officials estimate that about 36 percent of the government’s marketable debt — about $1.6 trillion — is coming due in the months ahead.

And that's not the whole story. Tyler Durden noted on November 1st:

As the assets on the US balance sheet become increasingly long-dated, courtesy of QE, and locking in record low rates, US liabilities in turn have shortened their duration to a record level. Almost $3 trillion in US debt will have to be rolled by the end of 2010.

But wait, that's just the existing debt that has to be rolled over. Then there's the new debt that has to be added to keep things rolling along:

Bill Bonner writes that his friend Porter Stansberry estimates the US government alone will need to finance $4.5 trillion worth of bonds next year.

Which, by the way, given that the US added close to $2 trillion in debt in 2009, seems almost certain to be a low ball estimate. It's more likely that the total amount of new and existing US 2010 debt will come in "comfortably" over $5 trillion.

Moreover, the official federal deficit recently broke through the $12 trillion mark. And all this is happening in a situation with very low interest rates. A quote from the NYT article: "The government is on teaser rates". Which seems a good comparison. And which cannot last forever. And no, it can also not last as long as Ben Bernanke wills it to. The $5 trillion US debt in 2010 will have to compete for buyers in a global market that can look forward to a minimum of $12 trillion in sovereign debt being available for purchase.

Perhaps the best shot the US government has in that market is for the stock markets to crash, since that will lift the US dollar, and free up a lot of financial space for the administration. Of course, it would also crash the banks and the housing industry, but then, they are goners anyway. Politically, job creation would be good. Let's see Washington add another $1 trillion to that debt load.

Mind you, CDS bets against Italy are through the ceiling, Greece may fall through the floor any day now, Spain moved into the basement months ago, Japan is celebrating a decade of rigor mortis and China is a bubble with 1.5 billion souls wearing brave faces who have no-one left to sell their earthly goods to.

Everybody has to keep on buying. Until they won't.

And when they no longer do, and they're busy stampeding through the exit, you can apply all the game theory you want.

Even If Stocks Are A Bubble, Everyone Has To Keep Buying

In his latest later, Raymond James strategist Jeff Saut argues that even if there is something like a bubble in stocks, everyone has to keep buying into it, or else they lose their jobs.
Thus, the trend remains your friend.
Nevertheless, we think the upside should continue to be driven by “game theory,” which suggests that the under-invested institutional portfolio managers have to buy stocks into year-end driven by their under-performance, their subsequent “bonus risk,” and ultimately their “job risk.” Verily, many of the portfolio managers we know remain under extreme pressure to commit their outsized cash positions in an attempt to “catch up” to their benchmarks between now and year-end (see the nearby Credit Suisse institutional cash versus retail cash on the sidelines chart).
Reinforcing that game theory point Jeremy Grantham notes:
“In markets where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone’s ultimate job description becomes ‘keep your job!’ (Manifestly) Career risk-reduction takes precedence over maximizing the client’s return.

Efficient career-risk management means never being wrong on your own, so herding, perhaps for different reasons, also characterizes professional investing. Herding produces momentum in prices, pushing them further away from fair value as people buy because they are buying.”
Jeremy goes on to note a couple of insightful points: “Refusing, on value principal, to buy in a bubble will, in contrast, look dangerously eccentric. And when your timing is wrong, which is inevitable sooner or later, you will in Keynes’ words – ‘Not receive much mercy’” – he sums up what that means to the folks who try not to go with the herd and do the right thing, “Today the challenge is not getting the big bets right. It’s arriving back at trend with the same clients you left with . . .”
Plainly, we agree with Mr. Grantham, which is why we continue to think the improving fundamentals, and earnings, will serve as the “carrot in front of the horse” to keep investors chasing stocks even if we do get a near-term pullback.

Bets rise on rich country bond defaults

The mounting level of debt in the industrialised world is prompting a growing number of investors to use the derivatives market to bet on the chance of rich governments defaulting on bonds. The volume of activity in sovereign credit default swaps – which measure the cost to insure against bond defaults – linked to the US, UK and Japan have doubled in the past year because of concerns about their public finances.

CDS volumes for Italy, which has one of the highest debt burdens of the developed economies, are now the highest for an individual country, according to the Depository Trust & Clearing Corporation. In contrast, the outstanding volume of CDS linked to emerging nations such as Russia, Brazil, Ukraine and Indonesia have been flat or fallen in the past 12 months as investors have become less interested in trading the risks of those countries.

In the past, the CDS market for developed countries was sluggish, because few investors saw the need to buy or sell protection against a risk of default that seemed exceedingly remote. However, rising debt levels and growing political and economic uncertainty has created a more active market, with more investors now seeking insurance. Meanwhile, many banks are prepared to offer protection in exchange for a fee. This fee has recently jumped, since the cost to insure the debt of developed countries has increased since the summer of last year, while the cost of insuring emerging market debt has fallen.

Gary Jenkins, head of fixed income research at Evolution, said: "The biggest single risk hanging over the bond markets is the rapid rise in public debt in the industrialised world. "If we get to a point where the market thinks the levels of debt are unsustainable, then we will see an almighty sell-off in the government bond markets, with yields soaring. Governments need to take action to cut deficits and debt." Fitch Solutions, the data arm of the Fitch Group, said that there is almost as much uncertainty in the CDS market about the outlook for the developed economies and their bond markets as there is for emerging economies.

Comparisons between Italy and Brazil are often used by strategists as an example of the contrasting fortunes of the developed and emerging world. Italy’s debt to gross domestic product ratio is forecast to rise to 127.3 per cent in 2010. On the other hand, Brazil’s debt to GDP ratio is forecast to stabilise at 65.4 per cent in 2010. Nigel Rendell, senior emerging markets strategist at RBC Capital Markets, said: "It is not surprising that investors are increasingly worried about debt in the industrialised world. Debt to GDP of more than 100 per cent is difficult to sustain."

Wave of Debt Payments Facing U.S. Government

The United States government is financing its more than trillion-dollar-a-year borrowing with i.o.u.’s on terms that seem too good to be true. But that happy situation, aided by ultralow interest rates, may not last much longer. Treasury officials now face a trifecta of headaches: a mountain of new debt, a balloon of short-term borrowings that come due in the months ahead, and interest rates that are sure to climb back to normal as soon as the Federal Reserve decides that the emergency has passed.

Even as Treasury officials are racing to lock in today’s low rates by exchanging short-term borrowings for long-term bonds, the government faces a payment shock similar to those that sent legions of overstretched homeowners into default on their mortgages. With the national debt now topping $12 trillion, the White House estimates that the government’s tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically. Other forecasters say the figure could be much higher.

In concrete terms, an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan. The potential for rapidly escalating interest payouts is just one of the wrenching challenges facing the United States after decades of living beyond its means. The surge in borrowing over the last year or two is widely judged to have been a necessary response to the financial crisis and the deep recession, and there is still a raging debate over how aggressively to bring down deficits over the next few years. But there is little doubt that the United States’ long-term budget crisis is becoming too big to postpone.

Americans now have to climb out of two deep holes: as debt-loaded consumers, whose personal wealth sank along with housing and stock prices; and as taxpayers, whose government debt has almost doubled in the last two years alone, just as costs tied to benefits for retiring baby boomers are set to explode. The competing demands could deepen political battles over the size and role of the government, the trade-offs between taxes and spending, the choices between helping older generations versus younger ones, and the bottom-line questions about who should ultimately shoulder the burden.

"The government is on teaser rates," said Robert Bixby, executive director of the Concord Coalition, a nonpartisan group that advocates lower deficits. "We’re taking out a huge mortgage right now, but we won’t feel the pain until later." So far, the demand for Treasury securities from investors and other governments around the world has remained strong enough to hold down the interest rates that the United States must offer to sell them. Indeed, the government paid less interest on its debt this year than in 2008, even though it added almost $2 trillion in debt.

The government’s average interest rate on new borrowing last year fell below 1 percent. For short-term i.o.u.’s like one-month Treasury bills, its average rate was only sixteen-hundredths of a percent. "All of the auction results have been solid," said Matthew Rutherford, the Treasury’s deputy assistant secretary in charge of finance operations. "Investor demand has been very broad, and it’s been increasing in the last couple of years."

The problem, many analysts say, is that record government deficits have arrived just as the long-feared explosion begins in spending on benefits under Medicare and Social Security. The nation’s oldest baby boomers are approaching 65, setting off what experts have warned for years will be a fiscal nightmare for the government. "What a good country or a good squirrel should be doing is stashing away nuts for the winter," said William H. Gross, managing director of the Pimco Group, the giant bond-management firm. "The United States is not only not saving nuts, it’s eating the ones left over from the last winter."

The current low rates on the country’s debt were caused by temporary factors that are already beginning to fade. One factor was the economic crisis itself, which caused panicked investors around the world to plow their money into the comparative safety of Treasury bills and notes. Even though the United States was the epicenter of the global crisis, investors viewed Treasury securities as the least dangerous place to park their money.

On top of that, the Fed used almost every tool in its arsenal to push interest rates down even further. It cut the overnight federal funds rate, the rate at which banks lend reserves to one another, to almost zero. And to reduce longer-term rates, it bought more than $1.5 trillion worth of Treasury bonds and government-guaranteed securities linked to mortgages. Those conditions are already beginning to change. Global investors are shifting money into riskier investments like stocks and corporate bonds, and they have been pouring money into fast-growing countries like Brazil and China.

The Fed, meanwhile, is already halting its efforts at tamping down long-term interest rates. Fed officials ended their $300 billion program to buy up Treasury bonds last month, and they have announced plans to stop buying mortgage-backed securities by the end of next March. Eventually, though probably not until at least mid-2010, the Fed will also start raising its benchmark interest rate back to more historically normal levels.

The United States will not be the only government competing to refinance huge debt. Japan, Germany, Britain and other industrialized countries have even higher government debt loads, measured as a share of their gross domestic product, and they too borrowed heavily to combat the financial crisis and economic downturn. As the global economy recovers and businesses raise capital to finance their growth, all that new government debt is likely to put more upward pressure on interest rates.

Even a small increase in interest rates has a big impact. An increase of one percentage point in the Treasury’s average cost of borrowing would cost American taxpayers an extra $80 billion this year — about equal to the combined budgets of the Department of Energy and the Department of Education. But that could seem like a relatively modest pinch. Alan Levenson, chief economist at T. Rowe Price, estimated that the Treasury’s tab for debt service this year would have been $221 billion higher if it had faced the same interest rates as it did last year.

The White House estimates that the government will have to borrow about $3.5 trillion more over the next three years. On top of that, the Treasury has to refinance, or roll over, a huge amount of short-term debt that was issued during the financial crisis. Treasury officials estimate that about 36 percent of the government’s marketable debt — about $1.6 trillion — is coming due in the months ahead.

To lock in low interest rates in the years ahead, Treasury officials are trying to replace one-month and three-month bills with 10-year and 30-year Treasury securities. That strategy will save taxpayers money in the long run. But it pushes up costs drastically in the short run, because interest rates are higher for long-term debt. Adding to the pressure, the Fed is set to begin reversing some of the policies it has been using to prop up the economy. Wall Street firms advising the Treasury recently estimated that the Fed’s purchases of Treasury bonds and mortgage-backed securities pushed down long-term interest rates by about one-half of a percentage point.

Removing that support could in itself add $40 billion to the government’s annual tab for debt service. This month, the Treasury Department’s private-sector advisory committee on debt management warned of the risks ahead. "Inflation, higher interest rate and rollover risk should be the primary concerns," declared the Treasury Borrowing Advisory Committee, a group of market experts that provide guidance to the government, on Nov. 4. "Clever debt management strategy," the group said, "can’t completely substitute for prudent fiscal policy."

Could sovereign debt be the new subprime?
by Gillian Tett

A few weeks ago, Claudio Borio, head of research at the Bank for International Settlements, warned in a solemn note to Group of 20 leaders that modern financial policymakers are "driving while just looking in the rear-view mirror": western finance officials have focused so much on past risks that they fail to spot new dangers. Worse still, as policymakers rush to implement reforms in response to one financial calamity, they are apt to create distortions that pave the way for the next disaster. Just such an unintended consequence could now be festering in the banking sector, as its balance sheets are increasingly stuffed with government bonds.

These days, there is a near-unanimous belief among western regulators that one way to prevent a repeat of the 2007-08 crisis is to stop banks taking crazy risks with subprime mortgage bonds or complex instruments such as collateralised debt obligations (CDOs). Instead, banks are being urged to hold a higher proportion of their assets in the form of "safe" instruments, most notably sovereign or quasi-sovereign debt. G20 regulators are holding regular meetings in Basel to draw up rules on how banks should do this, as part of a wider reform of financial regulation.

In theory, that move sounds very sensible. One reason why large banks crumbled last year was that many were carrying vast quantities of highly rated CDOs and other toxic paper. These not only lost their value during the crisis, but also became impossible to trade, creating a liquidity shock for the banks. Government bonds, by contrast, remained liquid during the recent crisis (and have been so in the past few decades). So it appears appealing to hold more of them, particularly given that sovereign debt is also widely presumed to be ultra safe; so safe that the yield on government bonds is known as the "risk-free rate".

But could this flight to the "safety" of government bonds in itself be creating subtle new dangers? Government debt, after all, has soared to levels not seen in peacetime for centuries, if ever, in many countries, not least the US and UK. Fiscal deficits are swelling across the western world. And the level of political commitment to curbing those deficits remains uncertain – not least because with yields currently so low there is less pressure on politicians to push through reform.

That does not necessarily mean an outright default looms any time soon; indeed, default seems highly unlikely. However, it is easy to imagine that some countries will end up eroding the value of their bonds by debasing their currencies in the coming years, printing money and stoking inflation. It is even easier to anticipate a sharp rise in bond yields – and a corresponding sharp fall in bond prices – particularly when central banks stop their quantitative easing programmes. Some smart hedge funds are betting on just that.

Yet there has been precious little debate about whether banks should keep loading up on sovereign debt. In Sydney, some Australian banks are grumbling about the Basel liquidity reforms. Ironically, that is because Australia is in the rare, happy position of having low(ish) debt levels, and its local banks fear they will struggle to find the bonds they need to meet the new G20 liquidity rules. In countries where there is likely to be a surplus of government bonds for sale, there is little public discussion at all. Perhaps that is because the banks do not wish to rock the boat; or maybe central banks themselves do not wish to draw attention to the swelling volumes of government bonds they now hold themselves.

Finance ministries are hardly likely to complain about the banks’ investments. Major industrialised countries will need to sell more than $12,000bn worth of government bonds this year and next to fund their fiscal hole. This is a rise of at least a third, or $3,000bn, in just two years. As Mr Borio notes, focusing only on that rear-view mirror is dangerous; whatever causes the next banking shock, it will not be mortgage CDOs. So I, for one, fervently hope that those banks holding government bonds are being cautious enough to hedge themselves against any future crash in their price; so too, for those holding quasi-government instruments, such as agency bonds.

I also hope that when the Basel regulators finally produce their new liquidity rules, the banks will have to build in a significant margin of error to reflect a potential fall in government bonds. This would underline the point to both banks and investors that government bonds are not automatically "risk-free". Most important of all, though, I hope that the current calm in sovereign debt markets does not lull politicians into thinking that they can indefinitely avoid the need to take difficult fiscal choices. For if they do, those "safe" government bonds might start to look considerably less secure – not just to bankers, but to everybody.

Greece tests the limit of sovereign debt as it grinds towards slump

Greece is disturbingly close to a debt compound spiral. It is the first developed country on either side of the Atlantic to push unfunded welfare largesse to the limits of market tolerance. Euro membership blocks every plausible way out of the crisis, other than EU beggary. This is what happens when a facile political elite signs up to a currency union for reasons of prestige or to snatch windfall gains without understanding the terms of its Faustian contract.

When the European Central Bank's Jean-Claude Trichet said last week that certain sinners on the edges of the eurozone were "very close to losing their credibility", everybody knew he meant Greece. The interest spread between 10-year Greek bonds and German bunds has jumped to 178 basis points. Greek debt has decoupled from Italian debt. Athens can no longer hide behind others in EMU's soft South. "As far as the bond vigilantes are concerned, the Bat-Signal is up for Greece," said Francesco Garzarelli in a Goldman Sachs client note, Tremors at the EMU Periphery.

The newly-elected Hellenic Socialists (PASOK) of George Papandreou confess that the budget deficit will be more than 12pc of GDP this year, four times the original claim of the last lot. After campaigning on extra spending, it will have to do the exact opposite. "We need to save the country from bankruptcy," he said. Good luck. Communist-led shipyard workers have already clashed violently with police. Some 200 anarchists were arrested in Athens last week after they torched streets of cars in a tear gas battle.

Mr Papandreou has mooted a pay freeze for state workers earning more than €2,000 a month. This has already set off an internal party revolt. "There is enormous denial," said Lars Christensen, emerging markets chief at Danske Bank. "They don't seem to understand that very serious austerity measures are needed. It is a striking contrast with Ireland," he said. Brussels says Greece's public debt will rise from 99pc of GDP in 2008 to 135pc by 2011, without drastic cuts. Athens has been shortening debt maturities to trim costs, storing up a roll-over crisis next year. Some €18bn comes due in the second quarter of 2010 (IMF). Modern economies have reached such debt levels before, and survived, but never in the circumstances facing Greece. "They can't devalue: they can't print money," said Mr Christensen.

The tourist trade is withering, down 20pc last season by revenue. Turkey was up. It is hard to pin down how much is a currency effect, but clearly Greece has priced itself out of the Club Med market. Wages rose a staggering 12pc in the 2008-2009 pay-round alone (IMF data), suicidal in a Teutonic currency union. Greece has slipped to 71st in the competitiveness index of the World Economic Forum, behind Egypt and Botswana. Greece has long been skating on thin ice. The current account deficit hit 14.5pc of GDP in 2008. External debt has reached 144p (IMF). Eurozone creditors – German banks? – hold €200bn of Greek debt.

A warning from Bank of Greece that lenders must wean themselves off the ECB's emergency funding has brought matters to a head. Default insurance on Greek debt jumped 40 basis points last week. Greek banks have borrowed €40bn from the ECB at 1pc, playing the "yield curve" by purchasing state bonds. This EU subsidy has made up for losses on property, shipping, and Balkan woes. The banks insist that they are in rude good health. EFG Eurobank has halved reliance on ECB funding. "Greek banks are very liquid: we maintain billions in extra liquidity," it said. Yet markets are wary. Recession has come late to Greece, but will bite deep in 2010. It takes three years for defaults to peak once the cycle turns.

David Marsh, author of The Euro: The Politics of The New Global Currency, said the danger for EMU laggards is that the ECB will begin to tighten before they are out of trouble. It is German recovery that threatens to stretch the North-South divide towards breaking point. Athens squandered its euro windfall. For a decade, EMU let Greece borrow at almost the same cost as Germany. It was a heaven-sent chance to whittle down debt. Instead, the country dug itself deeper into a hole by running budget deficits near 5pc of GDP at the top of the boom. Like Labour under Brown, idiot leaders mistook a bubble for their own skill. But the consequences in EMU are more dreadful. Austerity may prove self-defeating, without the cure of devaluation. Greece risks grinding deeper into slump.

The EU can paper over this by transfering large sums of money to Greece. But will Berlin, Paris – and London, also on the hook – feel obliged to bail out a country that has so flagrantly violated the rules of the club, not least by holding Eastern Europe's EU entry to ransom over Cyprus? That is neither forgotten, nor forgiven. During the panic last February, German finance minister Peer Steinbruck promised to rescue any eurozone state in dire trouble. He is no longer in office. The pledge was, in any case, a bounced political cheque even when he wrote it. Greece can assume nothing.

Dealing with America's fiscal hole

For years America’s fiscal problems had a surreal quality. No one disputed that an ageing population and health-care inflation could bust the budget, but that prospect was decades away and procrastination seemed painless. No longer. A giant hole has opened in the budget because of stimulus, bail-outs and a recession that has savaged economic growth and tax revenue. On current policies the publicly held federal debt, 41% of GDP last year, will double in the next decade. Total government debt will move well above the G20 average. In a few years the AAA rating of Treasury bonds, the world’s most important security, could be in jeopardy.

A sudden crisis is unlikely. Other rich countries with far bigger debts relative to the size of their economies, from Italy to Japan, have soldiered on without hitting a wall. Stable politics, transparent laws and economic dominance give America unequalled credibility with lenders. For all the anxiety the declining dollar drew from China this week, it has no serious rival as the world’s reserve currency. America has sensibly used this fiscal freedom to enact an aggressive stimulus programme. This should be maintained for as long as it is needed.

Yet ignoring the future is also costly. The problem is not the deficits in the next couple of years, but in the years that follow. Uncertainty over how taxes may be raised to shrink deficits may already be weighing on business confidence. Worries about inflation or default could start to push up interest rates. Eventually, private investment will be crowded out. Barack Obama and Congress can pre-empt such corrosive uncertainty with a plan to reduce the deficit now. Far from requiring immediate spending cuts or tax increases, a credible plan would reassure markets and allow an orderly exit from fiscal stimulus. The Federal Reserve provides a model: it does not plan to tighten monetary policy in the near future, but has signalled its willingness to do so when inflation threatens.

Where the cutting should begin
America’s deficit problem is in essence a spending problem, so spending must bear the brunt of adjustment. An ageing population and health-care inflation are inexorably driving up the cost of the country’s three big entitlements: Social Security (pensions), Medicare and Medicaid (health care for the elderly and the poor, respectively). Mr Obama has long promised that health reform would cover the uninsured without adding to the deficit, while reining in long-term costs.

Unfortunately, the prospects for controlling costs are tenuous. Achieving large savings will require action on many fronts. Raising the retirement age for Social Security and Medicare would save money while encouraging Americans to work longer, thereby expanding economic potential. Medicaid could be converted to block grants, compelling states to assume more of the burden of cost control. Other spending should also be vigorously squeezed, to stop federal funds being wasted on highways of dubious value or trade-distorting farm subsidies.

Still, cold arithmetic suggests that spending cuts alone cannot deliver enough. Changes to entitlements take effect only gradually. And the scope for slashing non-defence discretionary spending is limited, since it makes up merely one-sixth of total outlays. So Americans are stuck with a budgetary conundrum: they seem to be opting for more government, at least in health care, yet they do not seem prepared to pay for it. Their leaders have indulged this fantasy. Mr Obama has foolishly sworn off higher taxes on 95% of households, and Republicans will not countenance them for anybody. This newspaper strongly prefers small government and low taxes, but if Americans are to have bigger government and a sustainable budget, tax revenues will have to rise.

Taxing politics
Raising tax revenue will hurt less if the tax system becomes more supportive of economic growth in the process. Compared with other countries, America taxes consumption too little and income too much. Redressing this imbalance could, with time, help economic growth. First, broaden the income-tax base by eliminating exemptions, and if possible cutting rates. Second, introduce a carbon tax, the least distorting way to slow the growth in emissions. If that is not possible, sell rather than give away carbon-emission permits, or raise the federal fuel tax. A last resort is a broad consumption tax, such as a value-added tax. This is economically efficient, but could too easily become a politically convenient way to vacuum up more money and expand government.

The economics of fiscal reform are straightforward; it’s the politics that are tough. Mr Obama should start the process with a budget early next year that aims to stabilise, and preferably reduce, the debt-to-GDP ratio in the coming decade. The problem is getting Congress to pass the necessary laws. The polarisation of American politics has left Democrats more set on defending entitlements and Republicans determined to hold down taxes. With mid-term elections a year away, the incentive to compromise is shrivelling.

One way to finesse these toxic politics would be to establish a bipartisan commission to fix entitlements and taxes, as proposed by Kent Conrad and Judd Gregg, respectively the most senior Democrat and Republican on the Senate Budget Committee. Its membership would be drawn from both parties, both chambers of Congress and the White House. Democrats and Republicans alike would have to make sacrifices. To preserve this grand bargain, Congress would be allowed only to approve or reject the commission’s proposal, not amend it.

This is no magic bullet. Although similar processes have been used to negotiate trade deals, the stakes in this case would be far higher, as would the chances of failure. Republicans in particular may balk at co-operating. The commission could deadlock, or see its proposal voted down, precipitating the sort of market disruption the scheme was meant to avoid. But that actually may be an advantage: politicians may conclude that failure is not an option. The best defence against a crisis is to act as though you are facing one.

IMF warns second bailout would 'threaten democracy'

The public will not bail out the financial services sector for a second time if another global crisis blows up in four or five years time, the managing-director of the International Monetary Fund warned this morning. Dominique Strauss-Kahn told the CBI annual conference of business leaders that another huge call on public finances by the financial services sector would not be tolerated by the "man in the street" and could even threaten democracy.

"Most advanced economies will not accept any more [bailouts]...The political reaction will be very strong, putting some democracies at risk," he told delegates. "I do believe that the financial sector needs to contribute both to the costs of the financial crisis and to reduce recourse to public funds in the future," he said.

Mr Strauss-Kahn said that imposing high capital ratio requirements on banks was one price the financial services sector must pay to prevent the threat of further multi-billion dollar bailouts. He pointed to the debate in the US over the Troubled Asset Relief Programme and said that in many countries, including France and Germany, he doubted that politicians would secure the mandate needed to secure any further bail-outs if banks got in to trouble again, in several years' time.

Europe is in dispute over the spiralling cost of the global economic bailout, with Germany and France calling for a reduction in state support as their economies have shown signs of an upturn. In September, George Osborne, the Shadow Chancellor, sided with Germany and France, accusing Gordon Brown of being in "complete denial" over the mounting bill of the financial rescue packages and agreed with Britain's neighbours that it was time to look for an exit strategy. Countries are recovering from recession at different rates, with Britain lagging behind.

Mr Strauss-Kahn said that while the global economy had made "remarkable" progress in exiting recession, and was on the cusp of recovery, it remained "highly vulnerable" to shocks. He said state support for the world's battered economies must remain in place if a smooth recovery is to be achieved. "We recommend erring on the side of caution as exiting too early is costlier than exiting too late." Mr Strauss-Kahn is one of a series of high-profile speakers at the CBI conference, in Central London. Gordon Brown, David Cameron and Nick Clegg will all speak at the event as they seek to sway influential business leaders before a general election next year.

In his speech, Mr Strauss-Kahn also warned that the huge amounts of capital being pumped into China could fuel a pan-Asian bubble. His comments come after warnings from economists that the economic conditions in China and the rest of Asia are such that asset prices could rip free of their fundamental values unless the bubble threat is addressed. The Chinese banking sector is currently the scene of an unprecedented frenzy of new lending, which could reach up to 11,000 billion yuan (£97.7 billion) by the end of this year.

Mr Strauss-Khan said that the old paradigm of growth generation based on households in the US was dead. The future sources of growth and the recovery will "depend on a new balance between the US and deficit countries on one hand and emerging markets and surplus countries on the other". Emerging markets will provide some of the growth that the US can no longer offer, however he warned that while China and other emerging Asian economies were shifting from exports to domestic demand, they still had some way to go.

China banking regulator gets tough on capital rules

China's banking regulator issued a stern warning to banks to strictly comply with capital requirements or face sanctions, the latest signal that Beijing is worried about possible risks building in the country's financial system after a year of blow-out lending. Banks that fail to comply by the end of the year with capital adequacy requirements—the amount of capital they must hold against their loans—could be punished with limits on market access, overseas investments and new branches, the China Banking Regulatory Commission said in a statement on its Web site. Such sanctions already exist, but have rarely been enforced.

New loans in the first half of this year totaled 7.37 trillion yuan ($1.079 trillion), equivalent to half of the country's gross domestic product over the period, as the government turned to bank lending to power its economic stimulus plans. There are fears that the lending binge could saddle banks with large amounts of non-performing loans, reversing some of the gains achieved over the past decade of financial reforms that were aimed at turning China's state banks into commercial lenders better able to manage risk. The tough statement indicates that Beijing is ready to more actively tighten the credit growth that has been the linchpin of China's economic recovery.

Higher capital requirements act as a constraint on lending, as banks would need to raise additional money before they could make more loans. The capital adequacy requirement was raised to 10% from 8% at the end of last year. At the same time, banks were ordered to set aside credit provisions equivalent to at least 150% of their bad loans. More recently, the CBRC reduced the amount of subordinated bonds—debt that has a lower priority than other claims on an asset, and has higher returns— that banks could count toward their capital requirements. This was after it became apparent that banks were using the debt to lend money to each other, raising the risk that a default could ripple through the entire system.

A spokesman for China Construction Bank Corp, one of the Big Four state lenders, said the banking regulator "is considering imposing stricter capital requirements for lenders" next year, and the bank is closely monitoring the situation. Hu Changmiao said his bank "isn't yet sure" whether the CBRC will decide to raise its capital requirement and if so, by how much, because the regulator "hasn't issued any written notices." A CBRC spokesman said there "won't be any sudden changes" in banks' capital requirements. He denied a media report saying the regulator will require major state-owned banks to have a capital adequacy ratio of 13% from next year.

The spokesman said capital ratios are decided in a "counter-cyclical" way to address "systemic risks," language that indicates Beijing sees these regulatory requirements as one way to cool down a lending boom if it threatens economic stability. In the past, Chinese authorities have curbed overheated lending by imposing sweeping credit quotas. This time, they appear to be adopting a more market-oriented approach, while being prepared to use ad hoc administrative measures as necessary.

Last week, the regulator issued verbal instructions to a mid-sized Chinese state lender that it must limit outstanding loans for the last two months of the year to its level at the end of October, according to an internal bank memo shown to Dow Jones Newswires by a bank executive on the condition that his employer not be identified. The regulator denied issuing such a notice. No other banks seem to have been similar instructed. But medium-sized banks in particular have had trouble maintaining their required capital levels and loan-to-deposit limits, having been especially aggressive in using the stimulus boost to grant more loans and expand their market share. Beijing may be tempted to again directly cap some of their lending limits rather than hope they will adjust their loan portfolio to meet the requirements.

In its statement on Monday, the CBRC said it doesn't plan to impose any controls on the size of bank loans. It also said it aims to promote a stable and continued growth in bank lending, and prevent "big swings" in lending. Lending curbs were last imposed at the end of 2007 to cool an overheating economy, and were lifted in October 2008 with the onset of the global financial crisis. There is little likelihood that loan limits might be rolled out to the entire banking system. Although China is growing faster than any major economy, a sudden pullback in bank lending could shake the country's recovery.

A greater concern for Beijing is likely to be the fallout in two or three years if banks discover that many of their loans won't be repaid. China's last efforts to rid the financial system of non-performing loans five years ago cost the country hundreds of billions of dollars, and the experience is still fresh in regulators' minds. Bank lending has slowed somewhat over the last month, with banks extending 253 billion yuan of new yuan loans in October, the lowest level so far this year and less than half of September's amount. Fitch Ratings analyst Wen Chunling says the banking regulator faces a dilemma. "On the one hand it wants to alert banks over risks. But on the other hand it wants to avoid scaring people with too strong alerts," she said.

Existing Home Sales Surge on Cheap Condos
by Barry Ritholtz

Existing-home sales gained in October on a monthly basis as prices fell and cheaper homes predominated sales. Elevated inventory levels also declined.
Existing-home sales gained 10.1%, reflecting in large part an outsized seasonal adjustment. Sales were 23.5% above the 4.94 million-unit level in October 2008, when the collapse of Fannie, Lehman, AIG, Bank of America and Citigroup had paralyzed the nation.
Median existing-home price was $173,100 in October, down 7.1% from October 2008.
The biggest gains were found in the cheapest homes – especially condominiums and co-ops. Their sales surged 13.2% (seasonally adjusted) and were up an astonishing 40.8% above a year ago. Median prices for condos fell 10.4% below October 2008.
As expected, the prior month’s initial report was revised downward to annual pace of 5.54 million in September (originally reported as 5.57mm annualized). These revisions effectively eliminated the upside surprise of 220k sales last month.

It is noteworthy that the NAR claims the seasonally adjusted sales activity is at the highest level since February 2007 (6.55 million). CNN bought this nonsense hook line and sinker (Existing home sales at highest level since 2007) but it is not actually true without some accounting sleight of hand.
As the chart at right shows, the NSA data is quite unimpressive relative to the past few years.
Ultra low interest rates are helping sales somewhat. A 30-year, conventional, fixed-rate mortgage fell to 4.95% Last week, the 30-year rate dropped to 4.83%.
In addition to the low rates and the now extended first time homebuyers’ tax credit, a big spike in foreclosures is attracting bargain hunters. In parts of the country, some foreclosed units are selling for less than 50% of the peak 2005-06 price – especially on the low-end of the price scale. Foreclosure units have been selling briskly in California, Florida, Arizona, and Las Vegas.
Total housing inventory for sale fell 3.7% to 3.57 million existing homes, a 7.0-month supply at the current sales pace. This does not include a variety of so-called shadow inventory: REOs, rental units, vacation properties, and bank-owned strategic non-foreclosures.
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Seasonal Adjustments Continue to Skew Data:
Mark Hanson notes the ongoing skew of Seasonal Adjustments, and the continuing spin of the NAR:
The month of October was thought to be the end of the stimulus, so it reflects a last minute dash to get in before the tax credit sunset
Rates fell sharply to below 5% in Sept/Oct 2009
Despite this, Oct YTD sales are DOWN a whopping 716k from 2007
NSA sales were up 31k sales MoM to 499k in Oct — the exact same as Aug
NSA sales were up 86k sales from Oct 2008 – but in Oct 2008 rates were high (pre Fed QE) and there was not stimuli of any kind
Median and Avg prices fell again – about 1.5% MoM and 6% YoY – price drop accelerated into shoulder season as price dumping and short sales picked up
Year to date Oct 2008 vs Oct 2009 – 2009 sales finally passed 2008 sales by only 61k houses.

So in a nutshell, prices keep falling month after month and 2009 has produced 61k more real sales over 2008.
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chart courtesy Barron’s Econoday

Housing Leads the Economy, Existing Home Sales are Irrelevant (November 18)
by Calculated Risk

After reading some of the commentary regarding the housing starts report this morning, it might be useful to reiterate these three points:

Residential investment is the best leading indicator for the economy.

Residential investment will not recover rapidly because of the large overhang of existing vacant housing units.

Existing home sales are largely irrelevant for the economy.

Residential investment is reported quarterly by the Bureau of Economic Analysis (BEA) as part of the GDP report. We can also use monthly housing starts and new home sales as indicators of residential investment. I've written extensively about how residential investment is an excellent leading indicator for the economy (also see Dr. Leamer's paper: Housing and the Business Cycle)

This morning several commentators suggested that housing starts were depressed in October because of the expiration of the tax credit (new home buyers had to close by Nov 30th to get the tax credit), and also because of the weather. Probably. But the key point is that housing starts will not increase rapidly because of the large overhang of existing vacant housing units (see 2nd graph here). And that suggests that the economy will not recover quickly either.

Another key point is that existing home sales are largely irrelevant for the economy. This is an important point to remember next week when the NAR announces that existing home sales surged to 5.8 million units or so in October (seasonally adjusted annual rate). Some reporters and analysts will jump on the existing home sales report as evidence of a housing recovery. Others will point to it as showing that the first-time home buyer tax credit is helping the economy.

Both points are wrong. The only contribution from existing home sales to the economy are some commissions and fees. That is good news for real estate agents and mortgage brokers, but not for the overall economy.

The good news is the level of inventory for new and existing homes is declining. The bad news is the inventory of rental units is at record levels - as is the combined inventory of vacant single family homes and rental units. Residential investment will not increase significantly until this overhang is reduced.

The key to reducing the overall inventory is new household formation (encouraging renters to become owners accomplishes nothing in reducing the overall housing inventory). And the key to new household formation is jobs. And usually the best leading indicator for jobs is residential investment. Somewhat of a circular trap. And that suggests the recovery will be sluggish and unemployment will stay high for some time.

Geithner’s Crisis Sleepwalk Is Reason He Must Go

If Timothy Geithner were a Broadway show, the producers would shut it down. Treasury secretaries get attacked all the time and have to take it with aplomb. It’s in the job description. The criticism serves a purpose: A secretary who can withstand the withering attacks of congressmen has what it takes to manage a real crisis. Against this backdrop, Geithner’s performance last week was the most pitiful by a major economic policy maker in ages. Geithner broke the cardinal rule for Treasury secretaries. He lost his cool.

On the ropes at a hearing at the Joint Economic Committee on Nov. 19, Geithner defended himself with the only weapon in the Obama administration’s playbook: whining. But this wasn’t the hip, self-assured whining so artfully employed by President Barack Obama. It was shrill. It was unseemly. It was offensive. When Representative Kevin Brady, a Texas Republican, asked Geithner to resign, Geithner chose not to defend his actions. Instead, he pointed his finger back at Brady: "You gave this president an economy falling off the cliff."

After another Texas Republican, Michael Burgess, suggested that the government should offer tax relief to business and then get out of the way, Geithner took the question as an opportunity to bash the entire free enterprise system: "That broad philosophy helped produce the worst financial crisis and the worst recession we’d seen in generations." The problem, in Geithner’s view, seems to be that Brady, Burgess and other Republicans so messed up the world that even his brilliant policies have yet to fix the problem.

It is an iron law of Washington that policy makers lose their cool when they are on shaky ground in terms of substance. Geithner must know in his heart that he, far more than Brady or Burgess, is responsible for the financial crisis. That’s why minor political theater sets him off. Look at the facts. Geithner was president of the Federal Reserve Bank of New York for the five years leading up to the financial crisis. The crisis occurred, in part, because Wall Street firms spun out of control. The New York Fed is the cop charged with patrolling Wall Street, the eyes and ears of the financial regulatory system. It fundamentally failed on his watch.

Why did the Fed fail? Might it have been because it was run by a man who misunderstood the circumstances? Here is what Geithner had to say about financial markets in a speech in Atlanta in May 2007, just about a year before the crisis really ignited: "Changes in financial markets, including those that are the subject of your conference, have improved the efficiency of financial intermediation and improved our confidence in the ability of markets to absorb stress."

Later he added, "The larger global financial institutions are generally stronger in terms of capital relative to risk. Technology and innovation in financial instruments have made it easier for institutions to manage risk." That rosy description by a Fed president kind of makes you want to run out and buy stock in Lehman Brothers Holdings Inc., doesn’t it? No wonder the Fed failed to press the industry harder. It thought that financial innovations had worked a miracle. Geithner used to be asleep at the wheel in New York. Now he is asleep at the wheel in Washington.

The Treasury secretary is supposed to stand up for correct policy. This Treasury Department sat back and let Congress dictate a costly and ineffective stimulus plan. It looked the other way while politicos in the White House hatched a plan to produce false and laughable claims of jobs created from that stimulus, a procedure that is so flawed that it has attributed job creation to congressional districts that don’t exist.

He has allowed Democrats to play budget tricks to understate the costs of their health-care proposals by trillions, even as deficits soar to levels not seen since World War II. He failed to remind, or at least to convince, the president that a deep recession is a bad time for the government to increase fiscal imbalances by staging a takeover of health care. During the presidential campaign, Obama correctly pointed out that a cap-and-trade system to reduce greenhouse gas emissions should use an auction to distribute the pollution permits. Geithner snoozed while Congress decided to hand out the permits as political favors.

And don’t get me started on the dollar. The operatives in the White House clearly picked Geithner because they could count on him to look the other way while they play their economically destructive political games, just as he looked the other way while Wall Street undermined the economy. Geithner is a reliable political sidekick. As for substance, that is another story. New York Times columnist David Brooks wrote that when he asked him what government could do to promote innovation, Geithner "said that government’s limited job was to get the underlying incentives right so the market could figure out what innovations work best." Wait. Isn’t that the "broad philosophy" that produced the financial crisis? It is time for Geithner to go.

Jamie Dimon seen as good fit for Treasury

As support for Treasury Secretary Timothy Geithner wanes on Capitol Hill amid frustration with the Obama administration's handling of the economy, JPMorgan Chase CEO Jamie Dimon is emerging as a potential replacement.

Sources tell The Post that a number of policy makers have begun mentioning Dimon as a successor to Geithner, whose standing in Washington has suffered because of the country's high unemployment rate, the weakness of the dollar, the slow pace of the recovery and the government's mounting deficit. Last week, Geithner faced a withering attack from some Republican members of the Joint Economic Committee, getting into a testy exchange with one congressman who at one point asked Geithner if he would step down.

Dimon, meanwhile, has achieved rock star status during the financial crisis, having navigated JPMorgan through the recession and being a go-to guy when Uncle Sam last year needed Wall Street's help during the collapses of Bear Stearns and Washington Mutual. Furthermore, while many bank chiefs are facing heat over outsize bonuses, Dimon has repeatedly made clear he won't write fat checks to attract or keep talent.

People familiar with Dimon's thinking said he "would love to serve his country," and in recent weeks Dimon has had a noticeably higher profile in Washington, making frequent visits to government officials and earlier this month publishing an op-ed in the Washington Post that makes the case for letting large institutions that take big risks collapse rather than receive government aid.

"It is critical to the standing of the United States in the global financial economy to have a Treasury secretary who has the full support of the president and Congress; a person who has earned respect on their own as a result of hard-won battles in finance to represent this nation," said Dick Bove, a banking industry analyst at Rochdale Securities who this week will publish a report on Dimon. "That is not Timothy Geithner. It is Jamie Dimon."

The timing might be right for Dimon to pursue the Treasury post. He recently put into place a succession plan, and JPMorgan is currently considered one of the strongest banks in the country, even though it, too, faces a threat of sizable consumer-loan losses. However, sources said Dimon also has tried to tamp down enthusiasm for his replacing Geithner, whom the JPMorgan boss continues to support and thinks is doing "a good job," according to sources.

He doesn't want to be perceived as gunning for Geithner's job and is said to be keenly aware of the anti-Wall Street sentiment gripping the country. He has told people he plans to stay at JPMorgan for another "six or seven years," according to one source.

Dimon has long been a big Democratic supporter, and his ties with Obama go back to when he ran Chicago-based Bank One. In addition, White House visitor logs show Dimon has been a repeated guest there. He also was a point man during the previous administration, rescuing Bear and WaMu. This isn't the first time Dimon's name has been floated for Treasury secretary. He was considered a candidate last year and is still viewed as an executive who could be instrumental as Washington looks to overhaul the financial regulatory infrastructure.

Why is Obama Championing Bush’s Financial Wrecking Crew?
by William K. Black

Tom Frank’s book, The Wrecking Crew explains how the Bush administration destroyed effective government and damaged our social fabric and our economy. The Obama administration has chosen to reward two of the worst leaders of Bush’s crew — Geithner and Bernanke - with promotion and reappointment. Embracing the Wrecking Crew’s most destructive members has further damaged the economy and caused increasing political and moral injury to the administration.
Last week was a bad one for Geithner and Bernanke. Senator Dodd said that Bernanke’s confirmation was no longer a done deal. The House Financial Services Committee revolted against the administration, the Fed, and Chairman Barney Frank. It voted for a strong bill to audit the Fed. Senate Banking Chairman Schumer went to a conference at Columbia University — where a generation of students salivated at the prospects of Wall Street wealth — and was overwhelmed by an audience denouncing the continuing stranglehold of the finance industry over successive administrations and the Congress. Neither Barney’s blarney nor Schumer’s schmooze was any avail before an outraged public.
The administration promptly secured a column in the Washington Post claiming that the effort to fire Geithner “buoy[ed]” him because, as the subtitle to the article explained: “Even ex-Bush aides sympathetic, sources say.” The article didn’t note that Geithner is an “ex-Bush” senior official who, with his fellow “ex-Bush aides” (particularly Bernanke and Paulson) produced a chain of disasters: the bubble, an “epidemic of mortgage fraud” by lenders, the Great Recession, and the scandalous TARP and AIG bailouts. Of course they’re “sympathetic” to a fellow member of the Wrecking Crew that destroyed effective regulation and turned the nation over to Wall Street. The craziest part of the story is that the anonymous Obama administration flack that spread this anecdote believes that we should support Geithner because his fellow members of the Bush Wrecking Crew empathize with him because they, too, have been criticized for wrecking the economy.
The Washington Post article then offers a metaphor that serves as an apology for the Bush Wrecking Crew. The metaphor is driving over a cliff: “‘Secretary Geithner has helped steer the American economy back from the brink, and is now leading the effort on financial reform,’ White House spokeswoman Jen Psaki said.” Geithner pushed back against Republicans who questioned his performance, telling them, “you gave this president an economy falling off the cliff.”
You? How about we? Bush’s financial Wrecking Crew “gave this president an economy falling off the cliff.” Geithner was President of the Federal Reserve Bank of New York from October 23, 2003 until President Obama chose him as his Treasury Secretary. He was supposed to be the lead regulator of many of the largest bank holding companies. His failures as a regulator were a major cause of the “economy falling off the cliff.” Bernanke held prominent positions in the Bush administration from 2002 to the end of the administration and failed as a regulator an economist. Geithner and Bernanke failed to regulate even after the FBI publicly warned in September 2004 that (1) there was an “epidemic” of mortgage fraud and (2) it would lead to a financial crisis if it were not contained. Their refusal to take responsibility for the harm they inflicted on our nation as leaders of Bush’s financial Wrecking Crew adds to their unsuitability. Rewarding their perennial failures with a promotion and reappointment represents a dereliction of duty by the Obama administration.
The administration apologists praise Geithner and Bernanke for “steer[ing] the American economy back from the brink.” Greenspan, Paulson, Bernanke, and Geithner were the leaders of Bush’s financial Wrecking Crew. They were the guys blinded by their pro-Wall Street ideology that drove the car 120 mph down an icy mountain road and lost control of it. They took us to the “brink” of running “off the cliff” and creating the Second Great Depression. The bizarre claim is that we should praise them because they, and Wall Street, only wrecked the economy — they haven’t (yet) utterly destroyed it. Under their metaphor, we’re supposed to cheer Geithner and Bernanke because once they finally figured out that they were careening toward the cliff, they decided to sideswipe a row of trees in order to avoid going over the edge. They wrecked the car but they walked away from the crash without a scratch. If your teenager gets drunk, speeds, crashes into a school bus (injuring dozens of kids), and flips the Ford Focus — but walks away from the crash — you don’t praise him, give him the keys to the family minivan, and have him drive the soccer team to practices. You take all the keys away from him and ground him.
The Obama administration promoted Bush’s architects of the financial disaster and demands that we hail them as heroes. President Bush was ridiculed for saying: “Brownie, you’re doing a heck of a job.” FEMA administrator Michael Brown stood by while Hurricane Katrina reduced a single large city to ruin. Geithner and Bernanke stood by while scores of large cities were devastated.
I suggest that we will build on the momentum we’ve achieved on the Fed audit by making the following issues our near term financial priorities:
1. Can the Wrecking Crew. Fire the senior leaders of Bush’s and Clinton’s financial Wrecking Crews and stopping treating them as financial experts. President Obama should not reappoint Bernanke as Fed Chairman. He should dismiss Geithner and Summers and cease to take any advise from Rubin. Replace them with the Reconstruction Crew — people with a track record of getting things right and being effective economists, regulators, and prosecutors. Members of Bush’s financial Wrecking Crew run far too many regulatory agencies, often as “Actings.” They can, and should, be replaced promptly.

2. End “too big to fail.” These banks are “systemically dangerous institutions” (SDIs). They should not be allowed to grow. They should be shrunk to the point that they no longer pose systemic risk, and they should be subject to vigorous regulation while shrinking. They are too big to manage and too big to regulate. They are ticking time bombs that will cause recurrent global crises as long as they are SDIs.

3. More white-collar watchdogs. Adopt Representative Kaptur’s proposal to provide the FBI with at least 1000 additional white-collar specialists. Senator Durbin and (then) Senator Obama made a similar proposal several years ago.

4. No more executive compensation looting. End the perverse executive compensation systems that reward failure and fraud. The private sector has made compensation worse since the crisis. Modern executive compensation creates a virtually perfect crime — “accounting control fraud” (looting a company for personal profit). Until we fix the perverse incentives of executive compensation we will have recurrent epidemics of fraud and global financial crises.

5. Kill TARP and PPIP. Use the funds to help honest homeowners that would otherwise lose their homes because of predatory loan terms.

6. Make the Federal Reserve System public. It is a largely private structure that creates intense conflicts of interest and ensures that it is controlled by the systemically dangerous institutions. We have already decided that such a structure is inherently improper. The Federal Home Loan Bank System was set up along the same institutional lines and suffered from the same conflicts of interest. Congress ordered an end to these conflicts in the 1989 FIRREA legislation. It should end private control of the Fed.

7. Defeat any proposal to make the Fed the “Uberregulator.” The Fed, for inherent institutional reasons, is unsuited to be the “systemic risk regulator.” The Fed has never cared about regulation. The Fed cares about monetary policy and (theoclassical) economic theory and research. Regulation is, at best, a tertiary concern. Its economists wrote frequently about systemic risk — but missed the obvious, massive systemic risk of the financial bubble and the epidemic of accounting control fraud. Its policies intensified rather than restricting systemic risk. Theoclassical economists have no effective theories (or policies) to deal with bubbles or epidemics of accounting control fraud. Greenspan, Bernanke, and Geithner epitomize the Fed’s inability to recognize or reduce systemic risk. Their policies consistently increased systemic risk. Greenspan didn’t believe that the Fed should act against fraud. Geithner testified before Congress that he had never been a regulator (a true statement - but one that should have gotten him fired rather than promoted). Bernanke praised the subprime loans that caused the crisis and were so often fraudulent.

8. Ensure a robust CFPA. Sever the Consumer Financial Product Agency portion from the broader (and deeply flawed) regulatory reform bills in the House and Senate and adopt it into law. Revise the broader bill to strip out its many anti-reform provisions.

9. End the waste of long-term unemployment. Anyone able and willing to work should be employed by the government as an employer of last resort and should help repair our crumbling infrastructure. Paying people to do nothing or allowing them to become homeless (the status quo) is an insane system.

10. Adopt a $250 billion revenue sharing program. American state and local governments are in economic crisis. They are slashing spending at the worst possible time when their services are most vital and when cutting spending is pro-cyclical and will delay our recovery from the Great Recession. Revenue sharing was a Republican initiative. Republicans and “Blue Dog” Democrats killed the revenue sharing provisions of the administration’s proposed Stimulus bill. That was an enormous mistake. The federal government is not like a state government (or a household). It is a sovereign government with its own currency and a central bank. It can - and should - run large deficits during deep recessions, but the states and local governments cannot.

Revenue sharing is the ideal answer to the crisis and it is an answer with an impeccable conservative pedigree. State and local governments should come together and demand a program to offset the state and local cutbacks - roughly $250 billion. (The Obama administration’s claim that reducing the deficit should be a priority - at a time when unemployment has reached tragic levels - is economically illiterate. It repeats the error that FDR made when he listened to conservative economic advisors and slashed the budget deficit during the Great Depression - causing a surge in unemployment and the extension of the depression. The large federal deficits of World War II reversed the policies of his conservative economic advisors and ended the Great Depression.)

Fed's Bullard Wants Asset Buying Program Kept Alive After 1Q 2010

Federal Reserve Bank of St. Louis President James Bullard repeated Sunday it would be good to keep the Fed's asset buying program active beyond its current end date, to give the central bank more policy options should it need them. "I would just like to keep (the efforts) active at a very low level," Bullard said of the Fed's ongoing effort to buy mortgage related securities, done in a bid to help support economic growth. The official was speaking to reporters after an event held before students in New York.

Bullard was repeating what he'd told Dow Jones earlier Sunday. In that interview, he said he wants to see the central bank effort to buy mortgage backed securities maintained beyond the first quarter 2010's end. "I have advocated to keep the asset purchase program open but at a very low level, and wait and see what happens, and as information comes in about the economy we can adjust that program while the federal funds rate remains at zero," Bullard told Dow Jones Newswires. He added "no decision has been made" about the program's fate.

Citing the current level of the Fed's overnight interest rate target, Bullard said "as long as we are at zero (percent) we'd be able to send signals to the markets about what we are thinking about the economy, and how much accommodation the economy needs at various points, by adjusting the asset purchases." The central bank has committed to buying $1.25 trillion of agency mortgage-backed securities and around $175 billion of agency debt, as part of a bid to keep borrowing costs low and supportive of economic growth.

Bullard reiterated to reporters keeping the program alive would largely be aimed at keeping Fed options open, and any activity would not have an economic impact. He also repeated to reporters the outlook for Fed policy depends on what happens with the economy. When it comes to the economy, "I wouldn't say I'm worried," Bullard told reporters. "The economy has come in on track during the summer and the fall here" and "it looks like will do well here in the fourth quarter." But he added "I am a little concerned" about the reluctance to hire.

When it comes to some of the issues arising from commercial real estate problems, Bullard said "I am hopeful we'll be able to work with this and it will be contained." In his other comments at the event, Bullard told the audience what happened with the dollar during the financial crisis should allay fears about the currency's value. For all the fears about the dollar, "it is interesting the world came to the dollar" during the crisis, and that the currency rallied in the initial stages of the financial crisis. While the dollar has weakened of late, "at least right now the dollar is still viewed as the reserve currency" and "the place to go," and "we don't want to lose that," Bullard said.

In Bullard's formal remarks he noted growth had returned to the U.S., and he said household spending had stabilized. He described unemployment as "high" and said labor markets were lagging the recovery. The official said "the U.S. is in the early stages of recovery." In his remarks, Bullard said the problem of financial institutions that are deemed too-big-to-fail is real, and must be dealt with, because these institutions exact a cost on the financial system. Bullard defended the Fed's record during financial crises of the last generation, and he added Fed official did warn of the imbalances that led to the financial crisis of the last couple of years.

As financial reform efforts move forward, Bullard said he believes the Fed should remain a regulator of financial institutions. He also said this regulator role enhances monetary policy because it gives the central bank insight into the functioning of the financial system. Bullard also argued against moves that would compromise the Fed's independence, saying that would be bad for inflation and would complicate recovery efforts.

States Hit by Drop in Tax Collections

Tax collections tumbled 11% across 44 states in the third quarter, according to a report that suggests government revenue will remain depressed long after the economy has recovered from recession. Every major source of state tax revenue -- sales, corporate- and personal-income taxes -- fell in the third quarter compared with the same period a year ago, according to a report to be released Monday by the Nelson A. Rockefeller Institute of Government at the State University of New York.

The steepest decline was in volatile corporate-income taxes, which fell 19.4% across the 44 states surveyed by the Rockefeller institute. Personal-income taxes fell 11.4%, while sales taxes fell 8.2%. Roughly 80% of states' total tax collection comes from sales and personal-income taxes. With tax receipts heavily dependent on wages and spending, state revenues are expected to continue falling for months or years after the technical end of the recession. The economy continued to shed jobs in October, and employment growth is expected to remain muted even as the economy recovers. Many states could be forced to cut spending further.

"State tax revenues will remain fragile and gloomy at least throughout fiscal years 2010 and 2011," said Lucy Dadayan, a senior policy analyst at the Rockefeller institute. Each of the 44 states surveyed saw overall taxes decrease in the third quarter from a year earlier, and half saw total taxes fall 10% or more. The hardest-hit region was the Southwest, with third-quarter tax revenue falling 21.5%. Of the 38 states in the report that collect income taxes, all saw revenue declines, and 21 had double-digit-percentage declines.

The weakness in personal income taxes has for the most part mirrored the recession that began in December 2007. Far Western states, which have been among the hardest hit by falling home prices and the recession, recorded a nation-leading 15.3% decline in personal-income taxes. California, Oregon and Nevada all have unemployment rates greater than 11%, among the highest in the nation. The report added that despite new taxes and budget cuts in areas including legislators' salaries and higher-education funding, tax revenue is likely to continue falling short of expenses. Indeed, a report last week from California Legislative Analyst's Office showed the state is facing a $21 billion budget shortfall, and California's controller said the state could have trouble making payments as early as next spring.

"Further revenue shortfalls and more spending cuts are mostly likely on the way for many states -- particularly those that did not take significant actions to balance revenues and expenditures in their 2010 budgets," the Rockefeller institute concluded.

One in eleven US homeowners are at risk of losing their property

Almost one in eleven Americans is at imminent risk of losing their home, as the housing crash continues to claim thousands of victims, more than three years after prices began to fall. Data from the Mortgage Bankers Association show that almost 5% of all American homeowners are already in the process of having their properties repossessed, while another 4.5% are at least 90 days in arrears with their mortgage repayments. In total, that means more than 9% – almost one in eleven – are on the brink of being forced to hand back their keys, on top of the many hundreds of thousands who have had their homes repossessed since the crisis began.

"The underlying dynamic in the housing market is just dreadful," said Graham Turner, of consultancy GFC Economics. Treasury Secretary Tim Geithner recently persuaded Congress to extend the homebuyers' tax credit – part of President Obama's $800bn (£485bn) stimulus package – until next April. The scheme offers $8,000 to first-time buyers, but mortgage applications dropped off sharply in November, when it was due to expire. The White House, alarmed at the prospect of a renewed slump in the market, extended the credit, and opened it up to existing homeowners.

The US economy expanded at a healthy annual rate of 3.5% in the third quarter – though that may be revised down when new official figures are released this week. But Turner warned that without an end to the housing slump, any recovery will be short-lived, and the Obama White House will come under intense pressure. "We're going to have a political crisis. Obama realises that you can't keep spending money when it's not even having much effect. It will come to a head when the current tax credit expires in April – then people will say, enough is enough."

Wall Street Finds Profits Again, Now by Reducing Mortgages

As millions of Americans struggle to hold on to their homes, Wall Street has found a way to make money from the mortgage mess. Investment funds are buying billions of dollars’ worth of home loans, discounted from the loans’ original value. Then, in what might seem an act of charity, the funds are helping homeowners by reducing the size of the loans. But as part of these deals, the mortgages are being refinanced through lenders that work with government agencies like the Federal Housing Administration. This enables the funds to pocket sizable profits by reselling new, government-insured loans to other federal agencies, which then bundle the mortgages into securities for sale to investors.

While homeowners save money, the arrangement shifts nearly all the risk for the loans to the federal government — and, ultimately, taxpayers — at a time when Americans are falling behind on their mortgage payments in record numbers. For instance, a fund might offer to pay $40 million for a $100 million block of mortgages from a bank in distress. Then the fund could arrange to have some of those loans refinanced into mortgages backed by an agency like the F.H.A. and then sold to an agency like Ginnie Mae. The trick is to persuade the homeowners to refinance those mortgages, by offering to reduce the amounts the homeowners owe.

The profit comes when the refinancings reach more than the $40 million that the fund paid for the block of loans. The strategy has created an unusual alliance between Wall Street funds that specialize in troubled investments — the industry calls them "vulture" funds — and American homeowners. But the transactions also add to the potential burden on government agencies, particularly the F.H.A., which has lately taken on an outsize role in the housing market and, some fear, may eventually need to be bailed out at taxpayer expense. These new mortgage investors thrive in the shadows. Typically, the funds employ intermediaries to contact homeowners and arrange for mortgages to be refinanced.

Homeowners often have no idea who their Wall Street benefactors are. Federal housing officials, too, are in the dark. Policymakers have encouraged investors and banks to put more consumers into government-backed loans. The total value of these transactions from hedge funds is small compared with the overall housing market. Housing experts warn that the financial players involved — the investment funds, their intermediaries and certain F.H.A. approved lenders — have a financial incentive to put as many loans as possible into the government’s hands.

"From the borrower’s point of view, landing in a hedge fund or private equity fund that’s willing to write down principal is a gift," said Howard Glaser, a financial industry consultant and former official at the Department of Housing and Urban Development. He went on: "From the systemic point of view, there is something disturbing about investors that had substantial short-term profit in backing toxic loans now swooping down to make another profit on cleaning up that mess."

Steven and Marisela Alva say they do not know who helped them with their mortgage. All they know is that they feel blessed. Last December, the couple got a letter saying that a firm had purchased the mortgage on their home in Pico Rivera, Calif., from Chase Home Finance for less than its original value. "We want to share this discount with you," the letter said. "I couldn’t believe it," said Mr. Alva, a 62-year-old janitor and father of three. "I kept thinking to myself, ‘Something is wrong, something is wrong. This sounds too good.’ "

But it was true. The balance on the Alvas’ mortgage was ultimately reduced to $314,000 from $440,000. The firm behind the reduction remains a mystery. The Alvas’ new loan, backed by the F.H.A., was made by Primary Residential Mortgage, a lender based in Utah. But the letter came from a company called MCM Capital Partners. In the letter, MCM said the couple’s loan was owned by something called MCMCap Homeowners’ Advantage Trust III. But MCM’s co-founders said in an interview that MCM does not own any mortgages. They would not reveal the investor that owned the Alvas’ loan because they had agreed to keep that client’s identity confidential. Michael Niccolini, an MCM founder, said, "We are changing people’s lives."

In Washington, mortgage funds are lobbying for policies that favor their investments, particularly mortgages held in securitized bundles. They want more mortgage balances to be lowered, which might help mortgage bonds perform better. Big banks generally oppose such reductions, which lock in banks’ losses on the loans. In April, about a dozen investment firms formed a group called the Mortgage Investors Coalition to press their case. One investor who is speaking out is Wilbur L. Ross, who runs a fund that buys mortgages and owns a large mortgage servicing company.

Mr. Ross said modifications that simply lower interest rates or lengthen the duration of a loan, as is typical in the government modification program, do not work well. "They make a payment or two, but then one night the husband and wife will sit down at the table and say, ‘Do we really want to make 140 monthly payments into a rat hole?’ " Mr. Ross said. The Fortress Investment Group, a hedge fund in New York, is one of the firms at the forefront of picking through mortgages. Fortress created a $3 billion credit fund in 2008 partly to buy loans from banks like Citigroup, which were under pressure to purge loans to raise cash.

"They’re going ahead and they are refinancing them and getting their money out right away," said Roger Smith, an analyst at Fox-Pitt Kelton. "What Fortress is doing is actually good for the borrower." Congress, however, may not be happy that hedge funds are making money this way, Mr. Smith said. Fortress, which declined to comment, typically buys batches of loans and works with other companies to evaluate which ones might qualify for F.H.A., Fannie Mae or Freddie Mac refinancing. Sometimes Fortress works with Nationstar, a mortgage servicer and originator that it owns. Other times, Fortress uses an outside partner like Meridias Capital, a lender in Henderson, Nev., that once originated Alt-A loans, which are just above subprime.

After the mortgage market imploded, Meridias began dissecting portfolios of troubled loans for investment funds. Because firms like Fortress purchase blocks of mortgages at distressed prices, they are able to reduce the principal amount of the loans. Nick Florez, president of Meridias, calls such transactions an "incentive refinance." He said he would not agree to take a loan unless he could help the homeowner. He said he was able to reduce the loan amount by 11 percent on average. "I’m giving money away," said Mr. Florez, who is a 35-year-old Las Vegas native. "It’s really a feel-good business."

It is too early to know how the new loans will work. David H. Stevens, the new commissioner of the F.H.A., said he was monitoring F.H.A. lenders but did not have thorough information about which ones work with distressed investors. So far he has not seen a problem from loans coming from hedge funds. "They’re helping to protect people in their homes and they’re refinancing people from a distressed situation," he said.

But he acknowledged that funds have an incentive to aggressively push homeowners into federally guaranteed loans, since the investors get their money back as soon as they complete the refinancing. Seth Wheeler, a senior adviser in the Treasury Department who specializes in housing policy, declined to say whether the investment firms that are lowering principal for homeowners are altruistic or not. "Investors are doing it where it both benefits the investor and the borrower," he said.

Part of the risk may be determined by how the funds compensate the F.H.A. lenders and whether the lenders are beholden to the funds for business. David Zitting, the chief executive of Primary Residential Mortgage, the company that refinanced the Alva family’s loan, said his company did not receive fees from the hedge funds. "They have all sorts of motivations that, frankly, we don’t understand," he said. "We don’t do anything special for them because that’s not fair lending."

The Alvas had to dip into their savings to qualify for their new federally insured loan, since the biggest F.H.A. mortgage they could get was for $285,000, they said. They paid off $21,000 in credit-card and car loans, and put up an additional $29,000 for their new mortgage, depleting their already meager savings. Brian Chappelle, a mortgage consultant, said loans to people like the Alvas, with modest incomes and scant savings, could turn out to be risky. "It does raise risk concerns for F.H.A.," he said. The Alvas are grateful for the help. Their home is, Marisela said, a dream come true. "I’m very happy," she said. "We never thought this was possible."

The 70% Discount on Goldman's $500 Million Gift

It’s been dubbed the apology with a half-billion-dollar gift attached. In an attention-grabbing move this week, Goldman Sachs said it would launch a $500 million initiative to help small businesses with Warren Buffett as a key adviser, an announcement that coincided by hours with a public mea culpa from CEO Lloyd Blankfein for mistakes in the financial crisis. But it turns out Goldman’s program includes its own discount — the kind that only an investment banker could love.

According to a review of Goldman’s program by SmartMoney in consultation with corporate tax experts, the ultimate price tag of the initiative could be far less than the heavily publicized $500 million. A big chunk of the money is destined for charitable institutions, creating potentially sizable tax deductions for Goldman, while other portions are being made as loans that Goldman confirms it expects to be repaid with interest.

All in all, tax experts say, the ultimate cost to Goldman could total roughly $136 million to $150 million—70% or more below the half-billion figure that helped generate so much publicity for the firm this week. Interest income from the loans could lower the final bill even more. Asked about the estimates, a Goldman spokesman didn’t comment on the specific figures but defended the program as a boon to small businesses, while giving Goldman "a modest economic return." Buffett didn’t return requests for comment.

The program, titled 10,000 Small Businesses, drew a wave of media attention. Its advisory board includes Buffett, a big Goldman investor who is well known for his philanthropy, as well as Harvard Business School professor Michael Porter. While Goldman said explicitly that the small-business program was not designed as a public-relations move, many have interpreted it otherwise. Goldman has been the target of criticism for getting ready to pay out billions in bonuses to executives this year after benefitting from the U.S. government’s Troubled Asset Relief Program, or TARP, during the financial crisis—as well as for missteps that some say contributed to the meltdown.

On Tuesday, the same day Goldman announced 10,000 Small Businesses, Blankfein appeared before a room full of CEOs and journalists at an awards ceremony in which he was named CEO of the year by the Directorship Forum, and said Goldman had "participated in things that were clearly wrong and have reason to regret." Those comments suggested a turnaround from earlier this month, when Blankfein drew notice for being quoted in an interview with The Times of London saying he is a banker doing "God's work."

Here’s why the cost of 10,000 Small Businesses is likely to be lower than the $500 million figure. Half of those funds will be charitable contributions to community colleges and other nonprofit institutions to sponsor business education. At an all-in tax rate of 40% for state, local and federal obligations, that could give Goldman a $100 million savings on its taxes over the next five years, says Robert Willens, an independent tax and accounting analyst in New York and a former managing director at Lehman Brothers.

The rest of the Goldman discount is even simpler: Goldman should get back most or all of the $250 million it is also providing for loans to small businesses that a Goldman spokesman says are to be repayed in three to five years at "market rates" for nonprofit institutions that lend to small businesses. Market rates for that type of loan would generally range around 7% to 8%, according to Mark Pinsky, who consulted with Goldman on the program. Pinsky is president and CEO of the Opportunity Finance Network, a Philadelphia-based association of Community Development Financial Institutions, or CDFIs, which are nonprofit institutions that lend to small businesses.

"They’re not paying $500 million," says Benjamin Leff, a tax law professor at American University’s Law School in Washington, D.C. "They’re not even paying $250 million." The Goldman spokesman confirmed that the firm expected tax benefits from the charitable contributions and that it expected the funds being disbursed as loans would be repaid. "The program has a triple bottom line: We’re providing capital to underserved businesses, capacity building for CDFIs and a modest economic return to ourselves," says the Goldman spokesman.

To be sure, at a time when the credit crunch has made it much more difficult for entrepreneurs to secure loans, Goldman’s money will no doubt be welcomed by beneficiaries regardless of how the investment bank’s accounting works out. Already, the program is drawing widespread praise in the small-business community. Says Bill Dunkelberg, the chairman of Liberty Bell Bank, a community bank in Cherry Hill, N.J.: "Even though it’s like 1% of the company’s bonuses, it is nice to fund these things and I’m sure community colleges will appreciate the money." Adds Dunkelberg, "Small businesses can certainly use the money."

Goldman is also taking an obvious risk that it won’t get repaid on the loans. The default rate for these types of loans has traditionally been low – less than 1% prior to the recession, says Pinsky. However, since the downturn, Pinsky expects the default rate to reach 1.5%. To limit potential defaults, Goldman has tasked the program’s advisory board — including Buffett and Porter along with Blankfein — to select CDFIs that have track records of helping successful businesses. In addition, Goldman says it plans to lend only to companies that are at least two years old, have four employees ore more, and pull in revenue between $150,000 and $4 million in the most recent fiscal year.

What if a Recovery Is All in Your Head?
by Robert Shiller

Beyond fiscal stimulus and government bailouts, the economic recovery that appears under way may be based on little more than self-fulfilling prophecy. Consider this possibility: after all these months, people start to think it’s time for the recession to end. The very thought begins to renew confidence, and some people start spending again — in turn, generating visible signs of recovery. This may seem absurd, and is rarely mentioned as an explanation for mass behavior late in a recession, but economic theorists have long been fascinated by such a possibility.

The notion isn’t as farfetched as it may appear. As we all know, recessions generally last no more than a couple of years. The current recession began in December 2007, according to the National Bureau of Economic Research, so it is almost two years old. According to the standard schedule, we’re due for recovery. Given this knowledge, the mere passage of time may spur our confidence, though no formal statistical analysis can prove it.

Certainly, people did not always believe that there is a regular "business cycle" that starts and stops in a definite pattern. The idea began to spread in the popular consciousness in the 1920s and reached full bloom in the ’30s — with one major complication, the Great Depression, which received its name in midcourse, from a 1934 book with that title by Lionel Robbins. "There have been many depressions in modern economic history, but it is safe to say that there has never been anything to compare with this," Mr. Robbins wrote. In his narrative, the Great Depression was an extreme event, compared with ordinary "depressions."

"Recession," a kinder, gentler term, began to be used around the time of the 1937-38 contraction to refer to a normal downturn in the business cycle. In January 1938, The Chicago Daily Tribune offered a wry definition of a recession, calling it "a new word for depression, coined by those who don’t like to admit that we’re still in one." People joked so much about the euphemism that in 1938 President Franklin D. Roosevelt said, "It makes no difference to me whether you call it a recession or a depression."

The proliferation of the idea of a more-or-less predictable business cycle intersected with a rapidly growing public interest in psychology. Choice of words can matter greatly for the psychologically aware, and the new word "recession" had a much softer sound than its predecessor. Recessions, as the term came to be used, implied timetables that mark their expected end. Uttering the word does not risk damaging confidence, at least not fundamentally. A diagnosis of a recession can be shrugged off as something from which you will recover, as though your doctor had just diagnosed an illness as a common cold. A depression came to be another matter entirely.

Back in 1931, for example, The New York Times attributed the emerging economic cataclysm to a "mood of pessimism which had been carried to grotesque extremes." In 1932, it compared reckless talk about "depression" to shouting "fire" in a crowded theater. President Roosevelt is widely remembered for saying, in 1933, that "the only thing we have to fear is fear itself." But he was only repeating an oft-told message.

It wasn’t until 1948 that the Columbia University sociologist Robert K. Merton wrote an article in The Antioch Review titled "The Self-Fulfilling Prophecy," using the Great Depression as his first example. He is often credited with having invented the "self-fulfilling prophesy" phrase, but by the 1930s the idea was already as commonplace as the breakfast toast made with modern electric toasters. (Interestingly, the same Robert Merton documented the tendency for important ideas to be falsely attributed to celebrities.)

In fact, in 1937, "Think and Grow Rich," a book by Napoleon Hill, urged readers to adopt a positive mental attitude and to channel the power of the subconscious mind so that real wealth would follow. It became a runaway best seller. Faddish interest had already emerged not only in Freud’s theory of the unconscious mind, but also in the theories of the psychologist Émile Coué, who urged people to recite that "every day in every way I’m getting better and better." He said this "autosuggestion" would bolster the unconscious self.

In important ways, we are still using that 1930s pattern of thinking. We are instinctively fearful of reckless talk about depressions, and we try to support one another’s confidence. We like the idea that modern scientific economics seems to show that all recessions end in due course. For now, our common efforts at building confidence appear to be working somewhat. But the economy has still not recovered, by any means.

Couéism has been discredited generally, as has much of the old business-cycle theory, but they live on in our popular notions about recessions. We may hope that our resorting to euphemism and belief in timetables of business-cycle recoveries work better to restore confidence than they did in the ’30s.

The problem might be put this way: There is still a nagging doubt afloat that the current event is really just another example in that long sequence of recessions. In which mental category does the current contraction belong: recession or depression? We may still be at a tipping point. To the extent that the theory of the self-fulfilling prophecy is correct, there is a case for continued vigilance, to ensure that adverse events don’t encourage widespread talk of the second category.

November 21 2009: It's the stupid economy

2009-11-21T16:02:00.004-05:00

National Photo Co. Miriam Auerbach 1924

Ilargi: At times it seems overwhelmingly necessary to call spades spades, put some people in their rightful places, and subsequently flush them down. There are such copious amounts of half-truths, full-blown lies, carefully concocted spin and other forms of fantasy flying around the ether and other media channels that it must be impossibly hard for many to tell reality from garbage.

And I don't even want to go into the fellow finance writers who choose to put their entire credibility on the line with extremely poorly guided forays into climate science, spurred on as they are by a bunch of hacked emails, and concluding that "global warming is a scam". It may get them new fans, but they won’t be of the thinking kind, while those who are must now think twice when reading their words on other topics. By all means, guys, be my guest. But being unburdened by knowledge does not give you a license to speak. Not you, nor Palin nor Beck.

I would like to stick to the economy, with an inevitable side step into politics. It took less than a year for President Obama's approval numbers to fall below 50% for the first time, and that number -which finds its origin in a deteriorating economy- will increasingly shape policy, and to an extent not seen for quite some time.

Don’t be surprised if Tim Geithner is sacrificed unceremoniously and without much further hesitation. Not to thoroughly change economic policies or anything of that kind, don't be a fool. The pollsters are simply, as we speak, working overtime to see what Geithner's departure, combined with the potential nomination of one of a number of possible new candidates for his post, would do for Obama's popularity. Simple and cold calculation. It won’t be easy to find a candidate who would lift the poll numbers substantially. And policy wouldn't change anyway, since the Geithner Goldman clan will maintain a firm grip on the Treasury. One obvious candidate, Paul Volcker, seems to have disqualified himself with his resistance to the very popular Audit the Fed movement. No-one with a Goldman past has a shot.

But these are still all things that are out in the open, that we can see. We need, I think, to look much more closely at the reality of where the economy stands. ”It's the stupid economy" can have more than one meaning. Not unlike "It’s the stupid climate", for instance. It's very much an economy defined, shaped, presented and experienced by the stupid. And as long as that situation lasts, the select few fat fingers that are capable of actual thought can have their way with everybody else's wealth. As Dylan Ratigan aptly puts it: Why would banks use taxpayers’ money to do lending when they can take it and speculate in dark markets, and are allowed to do so by the government, where the profits are theirs and the losses can be returned to the taxpayer?

What we have seen in the first 11 months of the present administration is not just that those responsible for the mess have not been punished for their illegal acts, or that trillions in taxpayer money have "somehow inadvertently" ended up in the wrong hands. 2009 so far has seen a concerted and highly successful effort by those responsible for the crisis to get a much tighter grip on government finance, make legal what wasn't, free up unparalleled amounts of public money, and make sure it flows into their pockets. It's the simple and complete gutting of the entire US economy and, in its wake, American society.

It started -if we forget Alan Greenspan and Robert Rubin for a moment- in 2008 under Hank Paulson, with Geithner in a prominent role (which he now seeks to hide) at the New York Fed, and it grew exponentially once Geithner and Summers had been cemented into their places by the president. There is nothing accidental about this, it's not a question of mistakes due to wrong ”accents" or incomplete information, as many like to claim. Paulson and Geithner's TARP, as Elizabeth Warren says one again, had the specific and explicit purpose of boosting lending to small businesses. A year later, that lending is down. Need we say more?

The government suggests that the unemployment situation is improving, and is doing so because of its efforts. But while the Bureau of Labor Statistics' Non-Farm Payroll Survey claims that job losses have improved from minus 741,000 in January to minus 190,000 in October, the U3 unemployment rate has gone up relentlessly, from 7.6% in January to 10.2% in October. It has, moreover, done so in increments that don't have any apparent connection with the non-farm job loss numbers. How is that possible? The unemployment rate is based on a separate BLS survey, the Household Survey. In short, job losses are not coming down, or if they are, in much smaller numbers than it pleases Washington to publicly tout.

And we have talked enough about the difference between U3 and U6 numbers. Using U3 is just another method for Washington to make things look better than they really are. It seems that if you haven't called to say you have no job in the last 5 minutes, you’re no longer counted as jobless. It is then assumed that you either have become so discouraged you've decided to lay down and die, or, alternatively, you've discovered you're independent wealthy after all.

Which takes us to the next bit of rubble: the "success" of the stimulus package in creating jobs. Whatever you hear or see about that, rest assured: it's an unmitigated disaster. So much so that it's nigh impossible to believe that is accidental. The government resorts to downright lies about the program, 30,000 jobs in a district that doesn't even exist, a school that saves 600+ jobs where it only has 300 to begin with, it's a long list. Really, if the program were even a modest success in reality, you wouldn't hear these things, the spin doctors would make sure numbers would come in clean.

When confronted with doubts such as these, politicians et al. routinely claim that only a fraction on the allotted money has been spent, that it will all fall into place in 2010, and that they're on course to create the 3.5 million jobs Obama promised way back when. Well, if we may be so bold as to guesstimate that less than half of the jobs claimed as having been saved or created so far are real, then the total of some 300,000 created in the first 10 months of the program will just about have to be equaled every single month for the next 11 months. And lest we forget, Obama also claimed way back when that the stimulus would make sure the unemployment rate wouldn't rise beyond 8.1%. Yes, but we didn't have the data, yes, but nobody could have foreseen how bad it would get. Yes, yes. Call me.

It's interesting to note that no matter how hard it is to gauge how much has been spent on the job stimulus, what seems very clear is that the total amount Obama has delivered towards employment creation will by year end in all likelihood be less than the total amount in bonuses projected to be paid by Wall Street's main financial institutions. The total amount in Wall Street bonuses is set to exceed $162 billion, according to MSNBC, and if you ask me, that fact alone should be enough to bring down the president's poll numbers below the freezing point. By the way, MSNBC also estimates bank profits through Q3 ‘09 at $22.5 billion. $139.5 more in bonuses than in profits. Yes. Call me for that too.

So how do the media and their experts see all this? Here's for a last batch -for now- of spades called spades. The New York Times reports: New Consensus Sees Stimulus Package as Worthy Step. There are some gems here, on the topic of a second stimulus package, something I've long qualified as inevitable, and just as inevitably to be presented under a different name.

"It was worth doing — it’s made a difference," said Nigel Gault, chief economist at IHS Global Insight, [..] "I don’t think it’s right to look at it by saying, ‘Well, the economy is still doing extremely badly, therefore the stimulus didn’t work.’"

"The economy was weaker than we thought at the time, so maybe in retrospect we could have used a little bit more and little bit more front-loaded," said Joel Prakken, chairman of Macroeconomic Advisers, another financial analysis group, in St. Louis.

[..] Martin Feldstein, a conservative Harvard economist who served in the Reagan administration, said the problem with the package was that some of its tax cuts and spending programs were of a variety that did little to spur the economy. "There should have been more direct federal spending that would have added to aggregate demand," he said. "Temporary tax cuts and one-time transfers to seniors were largely saved and didn’t stimulate spending."

Among Democrats in the White House and Congress, "there was a considerable amount of hand-wringing that it was too small, and I sympathized with that argument," said Mark Zandi, chief economist of Moody’s Economy.com and an occasional adviser to lawmakers. Even so, "the stimulus is doing what it was supposed to do — it is contributing to ending the recession,"

Christina D. Romer, chairman of Mr. Obama’s Council of Economic Advisers, said attention to that too-rosy projection [Obama's claim that unemployment would halt at 8.1%] "prevents people from focusing on the positive impact of the fiscal stimulus. So of course I find that frustrating."

Economists said Republicans’ recent proposals to rescind unspent money would be a mistake. James Glassman, a senior economist at JPMorgan Chase & Company, said: "If we could be absolutely convinced that the growth we’re getting is for reasons beyond the help the government is giving, then that would make sense. But the fact is we can’t be certain of that."

These people don't live in America, these people are clowns that make up stories that fit their jobs and the worldviews connected with them.

The problem is not that the stimulus was too small, or that circumstances unpredictably deteriorated, or that too much went into tax cuts and not into spending.

The problem is that the government in 2009 has spent many times the amount spent on unemployment to hand out to banks.

The problem is that there still isn't even a actual plan, or a vision for that matter, for the future of America's people and their jobs. Or, if there is, it's not known, and likely for dark reasons. Perhaps the millions that lost their jobs this year and the millions more that are bound to follow them soon have already been written off as unnecessary hindrances to the greater glory of some. Why should we continue to feed those who can no longer produce additional profits for us?

The real problem for America is that the administration hasn't even tried to solve or mitigate or alleviate what is hurting American citizens. On the contrary, the average American is much worse off now than they were a year ago. They just don't know it yet. They will soon enough.

The problem, also, is that there's no way back. The trillions handed to the banks and the mortgage industry will not be returned, and neither can the government, whether it's this one or the next, spend as much again, not without doing -additional- irreparable damage to America's economy and society.

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Lawmakers want Geithner out

Commercial Real Estate Will Collapse
by Stuart Saft

The commercial real estate market is on its last legs and unless drastic actions are taken, the effects on the broader economy will be catastrophic. The obvious problem is the excessive amount of debt placed on the properties and the amount of debt that has to be refinanced during a relatively short period of time.

Between now and 2013, at least $1.3 trillion of financing comes due, of which $160 billion was the result of securitizations. Unfortunately, as a result of the virtual disappearance of the secondary market, the weakened condition of the banks, and the amount of debt already held by insurance companies and pension funds, even under the best of circumstances, less than half of the outstanding debt can be refinanced. This is compounded by the collapse of the commercial rental market in the last 18 months as a result of the Great Recession. For example, office rents in prime areas of Manhattan that were in the $100-$120 a square foot range in 2007 are now trading (with rent concessions and work letters) at half that amount.

After two years of one financial crisis after another, the Fed has fewer cards to play, and the foreign investors who bailed out commercial real estate investors in the past are sitting on the sidelines waiting for the prices to collapse. This problem is exacerbated by the lingering effects of the recession: absence of credit; growing job losses as a result of falling prices, consumer demand and credit; the insolvency or near insolvency of so many institutions; and the loss of confidence in the U.S. economy by our trading partners.

In the last few weeks there have been a series of court decisions that will have repercussions in the credit markets for years to come making an already cautious lending community absolutely paranoid, and restricting credit even if available. In Syracuse, N.Y., a state court refused to allow Citigroup to foreclose a mortgage on what was to be the second largest mall in the country even though it had no tenants. In a recent decision in the General Growth Properties bankruptcy, the court held that the special purpose entities structure was not bankruptcy-proof.

The court also ignored the fact that General Properties fired the independent directors of the special purpose entities and appointed new ones without telling anyone, including the fired directors, for seven weeks. Finally, last week in the Tousa bankruptcy in Florida, the bankruptcy court set aside the subsidiary's obligations and grants of security and ignored the savings clause in the loan documents to reverse a legitimate transaction meant to save the company.

The recent court decisions demonstrate how courts can override the words and intent of loan documents and lenders' remedies notwithstanding the widespread concern about the fiscal health of our lending institutions and the need for them to recover to unfreeze the credit markets and permit economic growth to resume. The media regularly contains stories about home owners who have been able to avoid foreclosure and have their debt canceled because of administrative or technical errors by the lenders. One would think that the courts believe that the money people borrowed to buy homes magically appeared and did not come from other people’s savings, investments and retirement accounts.

Has any court considered that, when they preclude a bank from foreclosing a mortgage, the home owner, who actually borrowed the money and is refusing to repay, is actually stealing the savings of their neighbors? So far, the courts seem to believe that they are playing the role of Robin Hood and ignoring creditors' rights. This behavior is also causing lenders to think twice before making loans.

As far as commercial loans are concerned, lenders have been hoping that something will happen to avoid their being required to either foreclose or declare a default. Both would have an immediate adverse impact on the lenders’ financial condition and could result in a need to raise more regulatory capital to avoid being taken over or merged into another institution or reporting another mess to their shareholders. However, delaying the recognition of the problem will not cause it to disappear.

In order to avoid a collapse that will result in a significant erosion of capital and the likely freezing of credit again with consequences worse than a year ago, the following steps should be taken immediately:

The Federal Reserve should provide a credit facility to commercial real estate owners as a lender of last resort with the government obtaining an equity interest (but not control) over the real estate in order to avoid the real estate from being dumped on the market, thereby further depressing values, which will also provide lenders with a way to liquidate their loans.

Lenders should not be required to appraise real estate that they own, are part of special assets or the subject of workouts using a mark-to-market standard but, recognizing the current aberration in the market place, using a "fair value" approach that recognizes the need to sell in an orderly transaction. What helped to destroy the S&L industry in the late 1980s and bring on the last real estate recession was the need of solvent banks to mark the real estate assets to market.

The City of New York (and the taxing authority in other jurisdictions) should reduce the real estate tax assessments on commercial properties to reflect the loss in value rather than making owners pay real property taxes based on assessments that are no longer relevant and then wait years to obtain a refund to help offset lost revenues.

Courts must begin to take cognizance of the fact that ignoring the terms of loan documents is not in the best interest of anyone except the owners of assets that no longer have value in excess of debt. Until the lenders begin to provide credit again, the economy is not going to grow and unemployment will increase.

Until the commercial market corrects itself, municipalities and states should suspend unfunded mandates that require large capital outlays by building owners that are not safety related (e.g., this is not the time to demand that buildings comply with new "green" standards) unless the municipality provides an economic benefit (i.e., tax abatements) to the property owner.

The Internal Revenue Code should be modified to suspend the passive activity rules and reduce the depreciation period for real estate acquired between 2010 and 2013 in order to make the acquisition of commercial real estate more attractive for domestic investors and offset the loss of value in the current market, which actions are just an income tax deferral and not a loss in revenue.

The Internal Revenue Code should also be modified to reduce the negative tax implications for foreign investors in purchasing and holding US real estate.

Finally, the federal government needs to focus on policies that will produce jobs and an environment that will spur job creation.

In all probability the subprime collapse and the damage done to the broader economy could have been averted by faster government intervention. In the current environment, there are just a few weeks left before phase two of the Great Recession commences due to the hundreds of billions of dollars in credit that will be lost from commercial defaults. Fixing the problem afterward will be far more expensive and damaging to the nascent economic recovery.

Warren: Wall Street comeback, Main Street plunge

Banks face major commercial real estate storm

Sooner or later, office buildings and other commercial real estate financed during the credit bubble will generate hurricane-scale losses for banks. Banks in recent years have been hammered by losses on home mortgages, buyouts and corporate defaults. Now, lenders face big losses from loans backed by commercial real estate, where a stagnant economy will eventually take its toll, financial services executives told the Reuters Global Finance Summit.

"The commercial real estate business still has not been marked down. It's not been marked to market," Cantor Fitzgerald LP Chief Executive Howard Lutnick said. "The economy can't, in my opinion, grow fast enough that the tenants are going to go out and start hiring and growing and building and take up all these rents at $60 a foot. It's nonsense." U.S. banks held $1.65 trillion of commercial real estate loans on their balance sheets as of November 4, according to the Federal Reserve. Total assets were $11.8 trillion.

Yet banks have postponed their day of reckoning, extending loans in hopes the economy will improve and demand for space will rebound. Banks have resisted selling assets, or taking them away from underwater borrowers, in fear of setting a new and lower market price. It is a strategy neatly summarized as "a rolling loan gathers no loss," Lutnick quipped. Lutnick, whose firm is now building out a real estate restructuring business, noted the equity invested in almost every transaction during the peak bubble years of 2005 through early 2007 has been wiped out. Lenders are under deep stress, because the value of their collateral has fallen.

But there is a limit to how long landlords can hold out for the old pre-recession rents. And once one building is marked down to reflect lower rents, neighboring buildings also should fall in value. Lutnick added most commercial loans come in the form of five-year balloon loans, so a wave of 2005-vintage assets will test creditors next year. "When you're in the eye of the hurricane, it sure feels good until you look at the TV screen and then you say, 'look, the hurricane is all around you,'" Lutnick said.

Banks do have a few things going in their favor. Chief among them is a friendly Federal Reserve, whose policy of free money lets banks reap windfall lending profits. "The Fed has pushed interest rates down to nothing. The spreads on portfolios and securities are generating a huge amount of net interest income," Broadpoint Gleacher Securities Group Chief Executive Lee Fensterstock said at the Summit. "That will enable them to resolve some of their commercial real estate positions." The commercial real estate problem also pales in size next to the previous waves of mortgage, leveraged loan, credit card and other consumer loan losses.

FBR Capital Markets analyst Paul Miller, while generally negative on banks, on Wednesday played down the danger of commercial real estate losses. "There's a lot of structural forbearance built into the commercial real estate market," Miller said, meaning it is easier for borrowers to postpone and amend their terms. Even so, the combination of poorly underwritten loans and a slowing economy will lead to many landlords walking away and handing over the keys. Individual credits, meanwhile, are much larger. "There's going to be a lot of empty buildings coming back to banks' balance sheets," Miller said.

Is a second stimulus coming?

U.S. Mortgage Delinquencies Reach a Record High

The economy and the stock market may be recovering from their swoon, but more homeowners than ever are having trouble making their monthly mortgage payments, according to figures released Thursday. Nearly one in 10 homeowners with mortgages was at least one payment behind in the third quarter, the Mortgage Bankers Association said in its survey. That translates into about five million households.

The delinquency figure, and a corresponding rise in the number of those losing their homes to foreclosure, was expected to be bad. Nevertheless, the figures underlined the level of stress on a large segment of the country, a situation that could snuff out the modest recovery in home prices over the last few months and impede any economic rebound. Unless foreclosure modification efforts begin succeeding on a permanent basis — which many analysts say they think is unlikely — millions more foreclosed homes will come to market.

"I’ve been pretty bearish on this big ugly pig stuck in the python and this cements my view that home prices are going back down," said the housing consultant Ivy Zelman. The overall third-quarter delinquency rate is the highest since the association began keeping records in 1972. It is up from about one in 14 mortgage holders in the third quarter of 2008. The combined percentage of those in foreclosure as well as delinquent homeowners is 14.41 percent, or about one in seven mortgage holders. Mortgages with problems are concentrated in four states: California, Florida, Arizona and Nevada. One in four people with mortgages in Florida is behind in payments.

Some of the delinquent homeowners are scrambling and will eventually catch up on their payments. But many others will slide into foreclosure. The percentage of loans in foreclosure on Sept. 30 was 4.47 percent, up from 2.97 percent last year. In the first stage of the housing collapse, defaults and foreclosures were driven by subprime loans. These loans had low introductory rates that quickly moved to a level that was beyond the borrower’s ability to pay, even if the homeowner was still employed.

As the subprime tide recedes, high-quality prime loans with fixed rates make up the largest share of new foreclosures. A third of the new foreclosures begun in the third quarter were this type of loan, traditionally considered the safest. But without jobs, borrowers usually cannot pay their mortgages. "Clearly the results are being driven by changes in employment," Jay Brinkmann, the association’s chief economist, said in a conference call with reporters.

In previous recessions, homeowners who lost their jobs could sell the house and move somewhere with better prospects, or at least a cheaper cost of living. This time around, many of the unemployed are finding that the value of their property is less than they owe. They are stuck. "There will be a lot more distressed supply entering the market, and it will move up the food chain to middle- and higher-price homes," said Joshua Shapiro, chief United States economist for MFR Inc.

Many analysts say they believe that foreclosures, instead of peaking with the unemployment rate as they traditionally do, will most likely be a lagging indicator in this recession. The mortgage bankers expect foreclosures to peak in 2011, well after unemployment is expected to have begun falling. There was one sliver of good news in the survey: the percentage of loans in the very first stage of default — no more than 30 days past due — was down slightly from the second quarter. If that number continues to decline, at least the ranks of the defaulted will have peaked.

"It’s arguably a positive, but it doesn’t undermine the fact that there are still five or six million foreclosures in process," Ms. Zelman said. The number of loans insured by the Federal Housing Administration that are at least one month past due rose to 14.4 percent in the third quarter, from 12.9 percent last year. An additional 3.3 percent of F.H.A. loans are in foreclosure. The mortgage group’s survey noted, however, that the F.H.A. was issuing so many loans — about a million in the last year — that it had the effect of masking the percentage of problem loans at the agency. Most loans enter default when they are older than a year.

When the association removed the new loans from its calculations, the percentage of F.H.A. mortgages entering foreclosure was 30 percent higher. The association’s survey is based on a sample of more than 44 million mortgage loans serviced by mortgage companies, commercial and savings banks, credit unions and others. About 52 million homes have mortgages. There are 124 million year-round housing units in the country, according to the Census Bureau.

U.S. Office Vacancies May Approach 20% Next Year

Office landlords in the U.S. will confront vacancy rates approaching 20 percent next year as employers hold off hiring, commercial property brokers Jones Lang LaSalle Inc. and Grubb & Ellis Co. said today. Jones Lang, the world’s second-biggest publicly traded commercial property firm, predicted vacancies will rise to 19.5 percent late next year, while Grubb & Ellis estimated a peak of 18.7 percent. "The road to economic recovery throughout 2010 will remain turbulent," Chicago-based Jones Lang said in a report. "While 2010 will be the year a global commercial real estate recovery begins, robust, broad-based growth is not expected until 2011."

Demand for offices, retail space and apartments dropped during the recession as rising unemployment cut the space needed to house workers and prompted consumers to reduce spending. The delinquency rate for all types of commercial real estate loans held by banks may top 10 percent by the second quarter of 2010, Jones Lang said. Offices will be the last type of commercial property to recover, said Robert Bach, chief economist for Santa Ana, California-based Grubb & Ellis.

Next year "won’t feel like a classic recovery, but it will certainly feel better than 2009," Bach said in a conference call. Higher U.S. office vacancies will reduce rents 5 percent to 7 percent in 2010, according to Jones Lang. Leasing may reach bottom in the fourth quarter of 2009. Leases are being signed at about 40 percent less than peak rates, said David Arena, president of Grubb & Ellis New York. Vacancies for all classes of Manhattan office space probably will reach 11.2 percent next year, up from 9.8 percent in 2009, Grubb & Ellis said.

In California, San Francisco’s office vacancies will be almost 18 percent next year, while Silicon Valley will see an increase to 22 percent, Grubb & Ellis’s Chuck Hunt said. Rents of top-quality offices in downtown San Francisco should start to rebound by 2011, according to Grubb. The vacancy rate in Los Angeles probably will rise in both 2010 and 2011, with a corresponding decline in the rents, according to Grubb & Ellis.

Average U.S. office values may fall as much as 50 percent from the top of the market in 2007 to the projected bottom in 2010, Josh Gelormini, head of capital markets research for Jones Lang, said. Almost $500 billion of commercial mortgages will mature annually the next few years, putting pressure on banks to either roll over the loans or foreclose on properties, Federal Reserve Chairman Ben Bernanke said in a Nov. 16 speech to the Economic Club of New York. "The performance of this sector depends critically on the ability of borrowers to refinance," Bernanke said.

Survey Shows Hard Times Before Recession

Even before the recession, more than one in five Americans could not afford to pay for basic needs without help from family, friends or outsiders, according to a survey by the Census Bureau. Fourteen percent of all Americans and 26 percent of blacks who responded to the 2005 survey reported that at sometime in the preceding year they were not able to meet essential expenses, like paying bills for basic needs, avoiding foreclosure and buying sufficient food.

"Presumably, this would be more severe than just being late with your utility payment," said Kurt J. Bauman, a bureau analyst. In addition to household income, a variety of measures of well-being were recorded in the bureau’s Survey of Income and Program Participation, which was released on Thursday. While 99 percent of the nation’s 113 million households reported having a refrigerator and a stove, that means that more than a million households lacked those appliances. Ninety-nine percent also said they owned a television.

The survey found that more American households had air conditioners and microwave ovens than computers. Since 1998, the share of households with a personal computer increased to 67 percent, from 42 percent. The poor, the elderly and people without a high school diploma were least likely to own one. Ninety percent owned landline telephones (down from 96 percent in 1998) and 71 percent owned cellphones (up from 36 percent). Among households headed by people under age 30, more owned cellphones (81 percent) than landlines (71 percent).

Since the survey was conducted well before the recession started in December 2007, presumably many measures of economic well-being have since gotten worse. Still, 9 percent of households over all and more than 25 percent of those below the poverty line could not afford nutritionally adequate food without resorting to food pantries or other emergency supplies, or to scavenging. Compared with the 1990s, people over all said they were more likely to expect help if they needed it from family, friends, social services agencies or religious institutions. Black and Hispanic respondents, though, were a little less likely to expect such help; blacks were a little more likely to have received it.

Generally, people surveyed were more likely than in the 1990s to say they were satisfied with the safety and overall condition of their neighborhoods. Still, in 2005, 20 percent of blacks said they stayed at home because they were concerned about their safety, and 32 percent of blacks said they were afraid to walk alone at night. Because respondents were not asked to elaborate, some of the results seemed anomalous. Almost the same proportion of householders lacking medical insurance said they were as satisfied with health services as those who were insured.

New Consensus Sees Stimulus Package as Worthy Step

Now that unemployment has topped 10 percent, some liberal-leaning economists see confirmation of their warnings that the $787 billion stimulus package President Obama signed into law last February was way too small. The economy needs a second big infusion, they say. No, some conservative-leaning economists counter, we were right: The package has been wasteful, ineffectual and even harmful to the extent that it adds to the nation’s debt and crowds out private-sector borrowing.

These long-running arguments have flared now that the White House and Congressional leaders are talking about a new "jobs bill." But with roughly a quarter of the stimulus money out the door after nine months, the accumulation of hard data and real-life experience has allowed more dispassionate analysts to reach a consensus that the stimulus package, messy as it is, is working.

The legislation, a variety of economists say, is helping an economy in free fall a year ago to grow again and shed fewer jobs than it otherwise would. Mr. Obama’s promise to "save or create" about 3.5 million jobs by the end of 2010 is roughly on track, though far more jobs are being saved than created, especially among states and cities using their money to avoid cutting teachers, police and other workers.

"It was worth doing — it’s made a difference," said Nigel Gault, chief economist at IHS Global Insight, a financial forecasting and analysis group based in Lexington, Mass. Mr. Gault added: "I don’t think it’s right to look at it by saying, ‘Well, the economy is still doing extremely badly, therefore the stimulus didn’t work.’ I’m afraid the answer is, yes, we did badly but we would have done even worse without the stimulus."

In interviews, a broad range of economists said the White House and Congress were right to structure the package as a mix of tax cuts and spending, rather than just tax cuts as Republicans prefer or just spending as many Democrats do. And it is fortuitous, many say, that the money gets doled out over two years — longer for major construction — considering the probable length of the "jobless recovery" under way as wary employers hold off on new hiring.

But there are criticisms, mainly that the Obama team relied last winter on overly optimistic economic assumptions and oversold the job-creating benefits of the stimulus package. Optimistic assumptions in turn contributed to producing a package that if anything is too small, analysts say. "The economy was weaker than we thought at the time, so maybe in retrospect we could have used a little bit more and little bit more front-loaded," said Joel Prakken, chairman of Macroeconomic Advisers, another financial analysis group, in St. Louis.

While some conservatives remain as skeptical as ever that big increases in government spending give the economy a jolt that is worth the cost, Martin Feldstein, a conservative Harvard economist who served in the Reagan administration, said the problem with the package was that some of its tax cuts and spending programs were of a variety that did little to spur the economy. "There should have been more direct federal spending that would have added to aggregate demand," he said. "Temporary tax cuts and one-time transfers to seniors were largely saved and didn’t stimulate spending."

Even the $787 billion price tag overstates the plan’s stimulus value given changes made in Congress, economists say. Nearly a tenth of the package, $70 billion, comes from a provision adjusting the alternative minimum tax so it does not hit middle-income taxpayers this year. That routine fix, which would do nothing to stimulate the economy, was added in part to seek Republican votes. But to keep the package’s overall cost down, provisions that would stimulate the economy — like aid to revenue-starved states and infrastructure projects — got less as a result.

Among Democrats in the White House and Congress, "there was a considerable amount of hand-wringing that it was too small, and I sympathized with that argument," said Mark Zandi, chief economist of Moody’s Economy.com and an occasional adviser to lawmakers. Even so, "the stimulus is doing what it was supposed to do — it is contributing to ending the recession," he added, citing the economy’s third-quarter expansion by a 3.5 percent seasonally adjusted annual rate. "In my view, without the stimulus, G.D.P. would still be negative and unemployment would be firmly over 11 percent. And there are a little over 1.1 million more jobs out there as of October than would have been out there without the stimulus."

Politically, however, the president is saddled with his original claim that, with the stimulus, the jobless rate would peak at 8.1 percent — a miscalculation that Republicans constantly recall. While the administration has said its economic assumptions were in line with private forecasts, most of which also underestimated the recession’s punch, it was more optimistic than most. "That was a mistake," said Jeffrey A. Frankel, a Harvard University economist and former Clinton administration official who is a member of the National Bureau of Economic Research panel that judges when recessions start and end. "I thought so at the time."

Christina D. Romer, chairman of Mr. Obama’s Council of Economic Advisers, said attention to that too-rosy projection "prevents people from focusing on the positive impact of the fiscal stimulus. So of course I find that frustrating."

Much federal infrastructure money has gone not to new job-creating projects but to finance existing plans, which otherwise would be unaffordable to states. So the stimulus has not "supercharged" transportation construction as was hoped, said Charles Gallagher, an asphalt company owner, speaking for the American Road and Transportation Builders Association, but it has nonetheless been "a welcome Band-Aid" to offset state cuts. "Many contractors across the nation have been able to sustain, if not add to, their work force," he said.

That sort of impact is what makes federal aid to state governments rank high in economists’ reckoning of the stimulus value of various proposals. Every dollar of additional infrastructure spending means $1.57 in economic activity, according to Moody’s, and general aid to states carries a $1.41 "bang" for each federal buck. Even more effective are increases for food stamps ($1.74) and unemployment checks ($1.61), because recipients quickly spend their benefits on goods and services.

By contrast, most temporary tax cuts cost more than the stimulus they provide, according to research by Moody’s. That is true of two tax breaks in the stimulus law that Congress, pressed by industry lobbyists, recently extended and sweetened — a tax credit for homebuyers (90 cents of stimulus for each dollar of tax subsidy) and extra deductions for businesses’ net operating losses (21 cents).

Economists said Republicans’ recent proposals to rescind unspent money would be a mistake. James Glassman, a senior economist at JPMorgan Chase & Company, said: "If we could be absolutely convinced that the growth we’re getting is for reasons beyond the help the government is giving, then that would make sense. But the fact is we can’t be certain of that."

Is the Fed Creating New Bubbles?

Its easy-money policy has Asia worried. But Bernanke says fears of a speculative surge are overblown. America's super-easy monetary policy has drawn a blast of criticism lately from the high and mighty of Asian finance. President Barack Obama and Federal Reserve Chairman Ben S. Bernanke stand accused of blithely ignoring the risk of new asset bubbles and more economic mayhem. As critics see it, the Fed helped inflate the tech and housing markets over the past decade and is setting up the global economy for another doozy with its near-zero short-term interest rates. Global investors can borrow dollars cheaply and invest the borrowed funds in assets ranging from Indonesian stocks to copper futures contracts, a strategy known as a carry trade. During Obama's recent Asian swing, China Banking Regulatory Commission Chairman Liu Mingkang warned that U.S. monetary policy is creating "new, real, and insurmountable risks to the recovery of the global economy, especially emerging-market economies." Bank of Japan Governor Masaaki Shirakawa and Hong Kong Chief Executive Donald Tsang issued similar warnings.

But there are two sides to this story. In detailed speeches and impromptu remarks, Bernanke and other top Fed officials have been making an interesting case that there's less to the much feared bubbles than meets the eye. First, they say few if any asset classes are obviously overvalued. Second, they say that trying to prick bubbles by raising interest rates could kill the nascent economic recovery. And third, they argue that the better way to cope with overheated markets is to strengthen financial institutions so they can withstand the inevitable bust—something Bernanke & Co. admit they've failed to do in the past. On Nov. 16, Bernanke and Vice-Chairman Donald L. Kohn made it clear in separate appearances that asset markets are not the focus of Fed monetary policy. The next day in Hong Kong, Federal Reserve Bank of San Francisco President Janet L. Yellen said, according to her prepared remarks, that it's "far from clear" that the Fed should "seek to lean against potentially dangerous swings in asset prices."

The Fed's seeming nonchalance about excesses isn't going over too well in U.S. financial circles. New York University economist Nouriel Roubini argues that the Fed is inviting speculative excesses in all kinds of risky assets by providing cheap dollar financing for what he calls "the mother of all carry trades." Massachusetts Institute of Technology economist Simon Johnson faults Bernanke's predecessor, Alan Greenspan, for ignoring the risk of bubbles and says, "The intellectual apparatus of Greenspan is still there." Adds Richard Bernstein, CEO of Richard Bernstein Capital Management: "[Bernanke] and Greenspan said that identifying bubbles was difficult, but that cleaning up after them was manageable. That has clearly been shown to be untrue." Actually, Bernanke isn't saying that it's impossible to outsmart the market and spot a bubble in the making—only that "it's extraordinarily difficult." Right now, he told an audience of 1,800 at a Nov. 16 Economic Club of New York luncheon, "it's not obvious to me that there's any large misalignments in the U.S. financial system."

The Fed chief has a point. Even though U.S. stocks have risen more than 60% since March, prices are within their historical range in relation to projected earnings for the coming year. Oil has more than doubled, to $80 a barrel from $34 in February, but that seems like a reasonable level with the bounceback in global demand. Treasury bonds don't seem overpriced given today's subdued inflation, and junk bonds are fetching normal premiums over Treasuries. Even emerging-market stocks and bonds, which many consider to be overpriced, are well within their historical ranges for value, says John Higgins, senior international economist for Capital Economics, a London consulting firm. Yes, gold at more than $1,000 an ounce does reflect fear among some investors about a resurgence of inflation, but the inflation expectations of the bond market and the public remain contained. Roubini's "mother of all carry trades" is not much in evidence, either. If lots of investors were borrowing dollars to invest in other assets, there would be an obvious spike in dollar loans. Instead, U.S. bank lending remains way off its peaks. Securitized lending in dollars by Wall Street firms is also down.

Complaints from China and Hong Kong about the Fed's low rates are even easier to dismiss. If they allowed their currencies to appreciate vs. the dollar, as the U.S. has urged, the threat of asset bubbles would quickly recede. The Fed has to set rates for the good of the U.S. economy, which is clearly still in need of cheap money. On Nov. 18 the Commerce Dept. reported an 11% drop in October in the annual rate of starts on housing construction. The unemployment rate of 10.2%, nearing a postwar high, is weighing on all sectors of the economy. Still, what if bubbles do start to form? The Fed says it will deal with them only to the degree that they affect its "dual mandate" from Congress—to keep overall prices stable and attain full employment. Jacking interest rates up and down in an effort to tame the stock market or other asset prices could cause bigger swings in prices and employment, Kohn said in a Nov. 16 speech at Northwestern University's Kellogg School of Management.

Instead of using interest rates to deflate bubbles, the Fed intends to employ what it calls "macroprudential regulation." That means regulating banks with an eye on markets, not just the bank's balance sheet. For example, a lending strategy that might look safe for any single bank is dangerous when lots of banks follow the strategy and all try to get out at once. One idea being pushed by the Fed and the Obama Administration is to require banks to tighten underwriting standards in good times, and build up thick capital buffers that could be used in bad times. "It's akin to caring for an entire ecosystem rather than individual trees," says Yellen.

The Fed's critics continue to worry that keeping interest rates near zero is the monetary equivalent of pouring gasoline on a fire. Paolo Pellegrini, who helped prick the housing bubble as a bearish hedge fund manager at Paulson & Co., says that trying to discipline markets through banking regulation while at the same time plying them with cheap money is "like having a very strongly worded law that says 'don't murder' and then going out and handing people lots of guns." The debate over how to deal with asset bubbles isn't going away. It's "perhaps the most difficult problem in monetary policy of the decade," Bernanke acknowledged at the Economic Club luncheon. For now, count on the Federal Reserve to keep interest rates extremely low until the recovery is well established—no matter what's happening in asset markets.

FDIC announces 124th bank failure

State regulators shuttered Commerce Bank of Southwest Florida in Fort Myers, Fla., Friday night, bringing the 2009 national tally to 124. Customers of Commerce Bank of Southwest Florida bank are protected, however. The Federal Deposit Insurance Corp., which has insured bank deposits since the Great Depression, currently covers customer accounts up to $250,000.

Central Bank in Stillwater, Minn., will assume all of the failed bank's $76.7 million in deposits, according to the FDIC. Central Bank also entered into a loss-share agreement with the FDIC on $61 million of Commerce Bank's $79.7 million in assets. The single branch of Commerce Bank will reopen on Monday as a branch of Central Bank. Customers of the failed bank can access their money over the weekend by writing checks or using ATMs or debit cards. Checks will continue to be processed, and borrowers should make mortgage and loan payments as usual.

The FDIC also said customers should continue to use their existing branch until they receive notice from Central Bank that the takeover has been completed. An average of 11 banks have failed per month this year, and the federal coffer is thinning under the massive strain. The fund now stands below $10 billion, down significantly from $45 billion a year ago. Friday's closure will cost the FDIC an estimated $23.6 million.

After factoring in expected closures, the agency says its insurance fund is in the red and will remain there through 2012. Over the next four years, the agency expects bank closures will cost $100 billion. The bank failure count for 2009 is still far from 1989's record high of 534 bank closures which took place during the savings and loan crisis, when the insurance fund also carried a negative balance. The tally is nearly five times the number that failed in 2008, and the highest tally since 1992 when 181 banks failed.

Grayson, Spitzer take aim at the Fed

China's 8.9% Growth? No Way
Gordon G. Chang

Beijing has spent its way to a sugar high.

On Oct. 22, Beijing announced that gross domestic product grew by 8.9% in the third quarter of 2009 compared with the corresponding period last year. The National Bureau of Statistics also reported that growth for the first three quarters was up 7.7%. The 8.9% figure confirmed the economy's upward trend. Growth, according to official statistics, tumbled to 6.1% in the first quarter, well off the double-digit figures seen in 2007 and the first half of last year.

The economy picked up during this year's second quarter, when it expanded 7.9%. Now it is clear that China will attain for 2009 at least the 8% target that Premier Wen Jiabao set in January. China's leadership is evidently satisfied. As the State Council noted on Wednesday, "The positive trend of recovery has been consolidated." How could it not have been? Since last November, Beijing has spent perhaps as much as $900 billion--from its own funds as well as those of the larger state banks--to jump start its $4.3 trillion economy. No government can disburse that amount of cash without creating some economic activity.

Yet China's economy, for all the stimulus it has received in 11 months, is underperforming. As an initial matter, reported third-quarter growth was slightly below the 9.1% consensus estimate of economists. More important, it is unlikely that 3Q expansion was anywhere near the claimed 8.9%. This claim is not consistent with other statistics. The economy, for example, is still dependent on exports: Before the massive government spending, about 38% of GDP was attributable to sales abroad. Yet exports tumbled 23.0% in July, 23.4% in August and 15.2% in September. Another important indication of slowing activity was the third-quarter drop in imports. They fell 14.9% in the first month of the quarter,17.0% in the second and 3.5% in the last.

And what took up the slack? The other two legs of the economy are, of course, investment and consumption. On consumption, retail sales, a crucial indicator of activity at China's shops, zoomed up during the last quarter, increasing by no less than 15.2% in any of the three months of the period.

There are fundamental problems with this key statistic, however. First, Beijing includes government purchases in the number as well as goods shipped from factories but not yet sold to consumers. Because the retail sales figures include these extraneous items, it is no wonder they do not correlate with statistics showing consumer price declines in each month of the July-September period--down 1.8%, 1.2% and 0.8%--plus increases in M2 in all three months. In September this broad measure of money in circulation jumped 29.3% after increasing 28.4% and 28.5% in the two prior months.

Because these numbers are consistent with trends evident throughout the year, we have to ask a simple question: How can a country have robust consumer sales, nagging deflation and rapid monetary expansion all at the same time? One reason is that vast quantities of consumer goods are now sitting in warehouses.

Beijing, in the 1990s, ordered factories to churn out goods in periods of low demand, and there are indications that officials are resorting to this tactic now. While optimistic analysts point to astounding car sales--up 70.5% in July, 94.7% in August and 83.6% in September--there are reports that central government officials have ordered state enterprises to buy fleets of vehicles and that these businesses are storing them in parking lots across the country.

These stories are as yet unconfirmed, but they are consistent with statistics showing that gasoline sales have been flat this year--up only 6.4% in August, for instance, and sliding since then from all indications. So here's another question: At a time when economic activity is supposedly rising at a quick pace, how can large increases in passenger vehicle sales not be accompanied by corresponding surges in fuel usage?

The answer is that Beijing's statisticians have gone back to their old tactic of making up figures to support the Politburo's predictions. The Chinese economy is probably growing due to state-led investment, but it cannot be doing so at the rates claimed. Wen Jiabao's stimulus plan is, above all, grossly inefficient. For all the money he is pouring into the economy, the country is getting a small return in economic output. That's why Premier Wen, despite the high growth numbers he's been reporting, consistently refuses to end his stimulus program. If his numbers were real, he would be worried about overheating. But he's apparently not.

Of course, Premier Wen should be concerned about the imbalances and dislocations that are developing due to his spending. Global investors immediately sent equity markets lower after Beijing's announcement of third-quarter growth as they were spooked by, among other things, China's over-reliance on stimulus and the lack of private investment.

They have every reason to be concerned. To create a "sugar high" of growth, China's central officials are busy renationalizing the economy, burdening the state banking system with loans that will go bad, undermining consumption by promoting investment, building excessive industrial capacity and engaging in mercantilist tactics to promote exports. The credit surge they're engineering will probably end up making Chinese enterprises less competitive, just as Japanese companies choked on too much money during their great bubble. The temporary advances in prices for Chinese stocks and property, the direct result of diverting Beijing's stimulus money into unproductive uses, are bound to scar the economy next year.

In the meantime, however, Beijing will continue to boast about its economic management . As a National Bureau of Statistics spokesman said on Thursday, "We can say we have made obvious and remarkable achievements in our economic growth." Unfortunately, for the Chinese people and the rest of us, that is not true.

Japan says economy back in deflation

The Bank of Japan moved towards a neutral stance on the risk of inflation on Friday even as the government formally declared that the world’s second-largest economy has entered deflation for the first time since 2006. The government’s declaration sets the scene for heightened tension with the bank, which has been resisting public calls by politicians for greater aggression in the fight against deflation. "We want the BoJ to extend support on the monetary policy front in overcoming deflation," said Naoto Kan, deputy prime minister. Hirohisa Fujii, finance minister, and Shizuka Kamei, financial services minister, have also called on the central bank to do more.

The bank’s policy board kept interest rates on hold at 0.1 per cent on Friday, but said "there is a possibility that inflation will rise more than expected" due to higher commodity prices, offset by a risk it could fall due to lower public expectations for medium- to long-term inflation. In previous statements it only mentioned the risk of inflation declines. The adjusted balance of risks suggests the bank is moving further away from the use of policy instruments such as quantitative easing. The bank said it would "maintain the extremely accommodative financial environment", however, indicating that no rise in interest rates is expected.

Consumer prices were down by 2.2 per cent on the previous year in September, or by 1.0 per cent excluding fresh food and energy. Although year-on-year inflation first turned negative in February, the government only now declared that "the Japanese economy is in a mild deflationary phase". The basic difference between the bank and the government is whether or not looser monetary policy can create inflation when factories are standing idle and there is limited demand to borrow. Japan’s experiment with quantitative easing earlier this decade created a large increase in bank reserves, but had a debatable effect on inflation, since only a small part was passed through to the economy via increased bank lending.

Takuji Aida, senior economist at UBS in Tokyo, said that the government’s fiscal stimulus was not enough and it should do more. "We think the government can do more to raise the expected inflation rate than the BoJ," Mr Aida said. In one indication that the government intends to maintain a high level of spending, Masayuki Naoshima, trade minister, told reporters that he supported an extension of incentives for scrapping cars in favour of new models, and subsidies for the purchase of more efficient televisions, refrigerators and air conditioners past their current expiry date in March.

Japan’s economy grew at an annualised rate of 4.8 per cent in the third quarter, fuelled by a mix of stimulus-induced domestic demand, a rebound in exports, and rebuilding of inventories. The central bank board strengthened its language on the current state of the economy. Rather than its October statement that the economy "is starting to pick up", it said the economy "is picking up". Economists are concerned whether the pace of activity will be sustainable once the fiscal stimulus measures expire. Separately, the lower house of parliament passed a debt moratorium bill calling on lenders to ease repayment terms for consumers and small businesses.

Ohio Sues Rating Firms For Losses In Funds

Already facing a spate of private lawsuits, the legal troubles of the country’s largest credit rating agencies deepened on Friday when the attorney general of Ohio sued Moody’s Investors Service, Standard & Poor’s and Fitch, claiming that they had cost state retirement and pension funds some $457 million by approving high-risk Wall Street securities that went bust in the financial collapse.

The case could test whether the agencies’ ratings are constitutionally protected as a form of free speech. The lawsuit asserts that Moody’s, Standard & Poor’s and Fitch were in league with the banks and other issuers, helping to create an assortment of exotic financial instruments that led to a disastrous bubble in the housing market. "We believe that the credit rating agencies, in exchange for fees, departed from their objective, neutral role as arbiters," the attorney general, Richard Cordray, said at a news conference. "At minimum, they were aiding and abetting misconduct by issuers." He accused the companies of selling their integrity to the highest bidder.

Steven Weiss, a spokesman for McGraw-Hill, which owns S.& P., said that the lawsuit had no merit and that the company would vigorously defend itself. "A recent Securities and Exchange Commission examination of our business practices found no evidence that decisions about rating methodologies or models were based on attracting market share," he said.

Michael Adler, a spokesman for Moody’s, also disputed the claims. "It is unfortunate that the state attorney general, rather than engaging in an objective review and constructive dialogue regarding credit ratings, instead appears to be seeking new scapegoats for investment losses incurred during an unprecedented global market disruption," he said. A spokesman for Fitch said the company would not comment because it had not seen the lawsuit.

The litigation adds to a growing stack of lawsuits against the three largest credit rating agencies, which together command an 85 percent share of the market. Since the credit crisis began last year, dozens of investors have sought to recover billions of dollars from worthless or nearly worthless bonds on which the rating agencies had conferred their highest grades. One of those groups is largest pension fund in the country, the California Public Employees Retirement System, which filed a lawsuit in state court in California in July, claiming that "wildly inaccurate ratings" had led to roughly $1 billion in losses.

And more litigation is likely. As part of a broader financial reform, Congress is considering provisions that make it easier for plaintiffs to sue rating agencies. And the Ohio attorney general’s action raises the possibility of similar filings from other states. California’s attorney general, Jerry Brown, said in September that his office was investigating the rating agencies, with an eye toward determining "how these agencies could get it so wrong and whether they violated California law in the process."

As a group, the attorneys general have proved formidable opponents, most notably in the landmark litigation and multibillion-dollar settlement against tobacco makers in 1998. To date, however, the rating agencies are undefeated in court, and aside from one modest settlement in a case 10 years ago, no one has forced them to hand over any money. Moody’s, S.& P. and Fitch have successfully argued that their ratings are essentially opinions about the future, and therefore subject to First Amendment protections identical to those of journalists.

But that was before billions of dollars in triple-A rated bonds went bad in the financial crisis that started last year, and before Congress extracted a number of internal e-mail messages from the companies, suggesting that employees were aware they were giving their blessing to bonds that were all but doomed. In one of those messages, an S.& P. analyst said that a deal "could be structured by cows and we’d rate it."

Recent cases, like the suit filed Friday, are founded on the premise that the companies were aware that investments they said were sturdy were dangerously unsafe. And if analysts knew that they were overstating the quality of the products they rated, and did so because it was a path to profits, the ratings could forfeit First Amendment protections, legal experts say. "If they hold themselves out to the marketplace as objective when in fact they are influenced by the fees they are receiving, then they are perpetrating a falsehood on the marketplace," said Rodney A. Smolla, dean of the Washington and Lee University School of Law. "The First Amendment doesn’t extend to the deliberate manipulation of financial markets."

The 73-page complaint, filed on behalf of Ohio Police and Fire Pension Fund, the Ohio Public Employees Retirement System and other groups, claims that in recent years the rating agencies abandoned their role as impartial referees as they began binging on fees from deals involving mortgage-backed securities. At the root of the problem, according to the complaint, is the business model of rating agencies, which are paid by the issuers of the securities they are paid to appraise. The lawsuit, and many critics of the companies, have described that arrangement as a glaring conflict of interest.

"Given that the rating agencies did not receive their full fees for a deal unless the deal was completed and the requested rating was provided," the attorney general’s suit maintains, "they had an acute financial incentive to relax their stated standards of ‘integrity’ and ‘objectivity’ to placate their clients." To complicate problems in the system of incentives, the lawsuit states, the methodologies used by the rating agencies were outdated and flawed. By the time those flaws were obvious, nearly half a billion dollars in pension and retirement funds had evaporated in Ohio, revealing the bonds to be "high-risk securities that both issuers and rating agencies knew to be little more than a house of cards," the complaint states.

Moody’s Says New York's Credit Rating Could Be Downgraded

Moody’s Investors Service this week warned that the state’s credit rating could be downgraded if the Legislature does not take serious steps to close the $3.2 billion budget gap and revenue continues to lag. The warning, released on Thursday, comes as Gov. David A. Paterson presses lawmakers to come to a consensus on how to address the deficit after weeks of sputtering negotiations. Mr. Paterson has urged reductions to schools and health care, which have long been third rails of state budget politics.

"This is a lot more serious than the interests of some of the legislators who would rather go home and be heroes saying, ‘Look, I didn’t cut school aid,’ or ‘Look, I didn’t cut health care,’ " Mr. Paterson said at a news conference Friday morning in Albany. "People had better get serious here." In its statement, Moody’s warned against one-time measures to close the gap, saying the state must address a stubborn reality: It is spending more than its revenue will support. Lawmakers, for example, have suggested that they may refinance the state’s tobacco bonds and use the proceeds to plug the hole for now, until the economy improves. "The next three months will be critical to the state’s credit rating," the Moody’s statement read.

A downgrading of the credit rating would make it harder and more expensive for the state to borrow money. The current rating is Aa3, Moody’s fourth-highest level. Though Mr. Paterson and legislative leaders have been negotiating for nearly two weeks, an agreement has eluded them as legislators have expressed reluctance to cut money for public schools and health care, which together account for more than half of the state budget.

Legislators are scheduled to return to session on Monday. On Friday several said they were not far from a deal, but negotiations appeared to have been complicated by worries about pressure from labor unions and public anger toward Albany, which has swelled this year after several political crises. But with the Thanksgiving holiday fast approaching and the state facing huge payments to local governments in December — about $1 billion to city and county governments and $1.6 billion to school districts — there is a growing sense that a vote on budget cuts cannot be put off much longer.

"I think none of us imagine we will go to Albany next week without getting this done," said Senator Liz Kreuger, the vice chairwoman of the Senate Finance Committee. "The clock has ticked about as far as it can." One compromise that legislators appeared to be moving toward on Friday involved using some leftover federal stimulus money to fund public schools so the state would not have to pay out of its depleted general fund. Ms. Krueger added that the discussions about reducing health care spending had progressed to the point that legislators were discussing which areas to cut, having agreed to an overall cut that would save approximately $400 million.

But whether the Senate’s proposals will satisfy the rating agencies and the governor, who must ultimately sign any deficit-reduction legislation, is an open question. The three major ratings institutions — Moody’s, Fitch and Standard & Poor’s — all give the state a good credit rating. But Fitch last week also cautioned that the state’s tax revenue was far off earlier estimates and said, "given the uncertainty in the economic and revenue outlook, downside risk remains."

Is $6,300 fair value for gold?

The last parabolic spike in gold took off when central banks joined the fray in the 1970s, hoarding bullion with the same enthusiasm as gold bugs. Dylan Grice from Société Générale says it smells much the same today. He sees an eery similarity between the decision of India’s central bank to buy half the IMF’s entire sale of gold, and the move by France’s central bank to start converting dollars into gold in 1965 — which was, of course, the start of the slippery slope leading to the collapse of Bretton Woods and the closure of the US gold window under Nixon. In the gold mania that followed, the price rose to levels that matched the US dollar monetary base (it reached 140pc at the peak). If that were to occur today after Ben Bernanke’s go at the printing press, gold would have to reach $6,300 an ounce. The US owns 263m ounces of gold while the Fed’s monetary base is $1.7 trillion. Simple equation.

Gold has had its ups and downs, of course. It is trading today at roughly the same real price as in the mid-13th Century — when an ounce bought a light suit of chain mail. It doubled in the late Medieval bubble, before crashing 90pc over the next 500 years after the Spanish gold discoveries by Cortes and Pizarro in the New World, and then the finds in California, Australia, and South Africa — bottoming around 1930. "Gold isn’t intrinsically safer than any other asset. There is nothing mystical about it either," said Mr Grice. However, precisely because gold is almost useless, it makes the perfect currency, and that is the role it is playing right now as flight from fiat paper leads to fresh records each day ($1150 yesterday).

Almost all western governments are insolvent. The total net liabilities of the US and France are both over 500pc of GDP. The UK and Germany are over 400pc. We are bust. To make matters worse — says Mr Grice — central bank credibility has been "permanently ruptured" by their collective failure to see the 2008 crash coming. (He is too polite: they caused the crisis by holding real rates too low for a decade, creating a debt bubble). Given that central bankers have been exposed as mortals/charlatans (ie pretending to command an exact science, when economics is merely a descriptive branch of anthropology), who can have much faith that they will manage the exit from emergency stimulus with skill?

Markets fear that central bankers will try to satisfy political masters by inflating away our debt. (Here too, I have my doubts: my concern is that they do not yet understand the deflationary dynamic underway, and will stay too tight, for too long, until we are in the Japanese abyss. Look at the 7pc annualized contraction of the M3 money supply {not the same thing as the monetary base, at all} in the US over the last three months, which Bernanke refuses to look at because he regards M3 as a barbarous Friedmanite relic.)

Mr Grice’s method is an odd way to calculate fair value of gold, but as good as any in a mania — and certainly no worse than ARPU ratios and "market cap to clicks" in the dotcom bubble. So perhaps gold is cheap. Personally, I take no view on this. As a contrarian, I never like an asset that is in fashion. I loved gold at $252 eight years ago. The higher it goes, the less I love it. Now, what asset today is as underpriced relative to the rest of the market as gold was in the depths of bear market in 2001? The Harare stock exchange looks a good place to start. Any other thoughts?

Stimulus-Jobs Tally in Doubt

The White House stepped back Thursday from its tally of the number of jobs its economic-stimulus package has created or saved through September in the face of mounting criticism over errors in reports filed by recipients of stimulus money. The move came after a testy hearing Thursday of the House oversight committee in which Earl Devaney, chairman of the Recovery Accountability and Transparency Board, which is responsible for monitoring the stimulus, said the number of jobs displayed on the official government stimulus Web site, recovery.gov, at 640,329 was possibly inaccurate.

"It may be a fact that that's what's on my Web site, but that may not be the correct number," Mr. Devaney testified. Hours later, administration officials organized a conference call for reporters and said that the overall total of jobs credited to the stimulus could be lower or higher than the number claimed on the Web site. White House officials didn't offer a precise tally of jobs. Instead, they sought to focus attention on some economists' estimates that without the stimulus, as many as one million more people could be without jobs now. "While the data may be imprecise," the overall conclusions of the stimulus plan's impact are "irrefutable," White House senior adviser Ed DeSeve told reporters.

The House hearing also reviewed a report from the Government Accountability Office, the investigative arm of Congress, which raised questions about 58,000 jobs claimed to have been created or saved by stimulus recipients who said they had not yet received any money. Administration officials said in a blog post released Thursday afternoon that it is possible to see job creation before a recipient gets stimulus money because hiring decisions can be made in the expectation that funds are on the way. The administration has been scrambling in recent days to respond to growing evidence that the data underlying its claims that the stimulus "created or saved" the equivalent of more than 640,000 full-time jobs is flawed in a variety of ways.

Thousands of recipients of stimulus money ranging from small contractors and nonprofit organizations to state and local governments struggled to complete lengthy forms designed to account for stimulus spending and the resulting jobs. In the process, some stimulus recipients claimed to have created jobs that didn't exist, reported spending money they hadn't received, and listed their addresses in nonexistent congressional districts.

Republicans in Congress have pointed to the discrepancies to bolster their arguments that the $787 billion stimulus program hasn't achieved Mr. Obama's goals and hasn't been effective in reversing the rise in unemployment, which is now just over 10%. Some Democrats have also expressed frustration with the shifting accounts of how many jobs can be linked to stimulus spending. The confusion over stimulus jobs comes as House Democratic leaders are trying to fashion a new job-creation measure, and the White House is gearing up for a jobs "summit" in early December.

Most States See Higher Jobless Rates

Unemployment rose in 29 states in the U.S. during October, hinting the threat posed by weak labor markets to the economic recovery might be growing. Labor Department data Friday said 29 states and the District of Columbia recorded unemployment-rate increases from the prior month, while 13 states had rate decreases, and eight states had no rate change. A month earlier, Labor had said 23 states and the District of Columbia reported over-the-month unemployment rate increases in September, while 19 had decreases and eight states had no rate change.

Friday's state-by-state jobless data came two weeks after the Labor Department reported the unemployment rate for the whole country climbed in October to 10.2%, a 26-year high. Persistent labor-market weakness threatens the economy's recovery from the severe recession. "The best thing we can say about the labor market right now is that it may be getting worse more slowly," Federal Reserve Chairman Ben Bernanke said this week. Of all 50 states in October, Michigan had the highest jobless rate, at 15.1%. Nevada was second, at 13.0%. North Dakota was lowest, with 4.2%.

The data showed October non-farm payroll employment increased in 28 states and the District of Columbia, while falling in 21 states and remaining unchanged in one state. Labor two weeks ago said U.S. non-farm payrolls shrank by 190,000 jobs. A separate report Friday said the number of U.S. workers involved in mass layoffs during April fell, the second straight decline. The Labor Department said mass layoffs events in October totaled 2,127 on a seasonally adjusted basis, down from 2,561 in September. Mass layoff events involve 50 or more people at a single employer losing their jobs.

The number of workers involved in the mass layoff actions totaled 217,182, down from September's 248,006. These people are identified as new filers for unemployment insurance. The latest data show new claims for jobless benefits remained steady at 505,000 last week, while the number of continuing claims fell by 39,000 to 5,611,000 in the preceding week. Since the recession began in December 2007, the number of unemployed has increased by 8.2 million and the unemployment rate has grown by 5.3 percentage points.

Mr. Bernanke said jobs are likely to remain scarce and inflation low for some time. The Fed on Nov. 4 decided to keep its benchmark interest rate at a record low zero to 0.25%, citing a sluggish recovery. The central bank said it expects to keep its federal funds target rate close to zero for an "extended period" in the face of high unemployment and low inflation. For the first time, the Fed's rate-setting committee earlier this month spelled out the three key indicators it will be looking at to set rates: unemployment, core inflation and inflation expectations. "Both the decline in jobs and the increase in the unemployment rate have been more severe than in any other recession since World War II," Mr. Bernanke warned.

The jobless recovery is on the way, says OECD

But public borrowing reached £11.42bn last month Figure was highest for the October since records began. The spectre of a global "jobless recovery" was conjured up yesterday by the Organisation for Economic Cooperation and Development, which predicted that "the economic recovery now spreading across OECD countries is still too timid to halt the continuing rise in unemployment". The warning came as the latest evidence on the supply of credit to the British economy showed little sign of radical improvements. The Bank of England's Trends In Lending Report confirmed that British consumers were still paying off their credit card and other consumer debts, while lending to businesses fell across all the main sectors of the economy in the third quarter of the year. The OECD's latest Economic Outlook also said Britain's public finances were weak and required "concrete" plans to bring the deficit under control.

The overhang of debt around the developed world, said the OECD, is the major factor holding back a more vigorous recovery and the creation of thousands more new jobs. Pressure on public finances will also dampen public-sector employment growth in the the next few years. The OECD expects the jobless rate to peak in the first half of 2010 in America, but it may not be until 2011 that unemployment begins to fall in the eurozone area. The report says the recovery is tepid because economic activity is being held back by families and businesses repairing their finances and reducing their debts. China, the OECD predicts, will lead the global recovery, helped by its limited direct exposure to the financial crisis and by a massive stimulus package. The US, the world's largest economy, is expected to grow by 2.5 per cent in 2010 and a further 2.8 per cent in 2011.

The OECD forecasts that the UK's growth will be 1.2 per cent this year and 2.2 per cent in 2010, "supported by improving financial conditions, an expansionary monetary policy and stronger international growth". But it adds: "The weak fiscal position makes further consolidation necessary; an announcement of concrete and comprehensive consolidation plans upfront would enhance macro- economic stability. Strengthening financial regulation and supervision would also support stability and hinder a build-up of new imbalances at historically low interest rates." The Bank of England's review of bank lending suggests that subdued demand for funds from companies is becoming a more significant factor, rather than the usual complaint that the banks are refusing funds to companies. The Bank reported: "Overall, demand for new bank lending was expected by the major UK lenders to remain subdued during the remainder of the year. The outlook for 2010 would depend on the prospects for working capital and mergers and acquisitions activity in particular. On the supply side, the major UK lenders noted signs of increasing competition."

Nor is the mortgage market much livelier. The Council of Mortgage Lenders said yesterday that gross mortgage lending in October was an estimated £13.5bn – 5 per cent more than the £12.9bn in September but 27 per cent lower that the £18.5bn borrowed in October 2008. The CML said last month's jump was caused by seasonal factors. Its economist, Paul Samter said: "There has been a significant change in the type of lending taking place. House purchase activity has picked up significantly. In contrast, remortgaging has dropped to decade-low levels as many borrowers have little incentive to refinance when they move on to low reversion rates, and others find themselves unable to do so because of equity constraints."

There was cheer on the high street yesterday when the Office for National Statistics (ONS) said that retail sales had jumped by 0.4 per cent in October. Shoppers buying early Christmas presents and those looking to avoid the reintroduction of the 17.5 per cent VAT rate in January pushed sales of non-food items by 0.6 per cent, compared to September, including a 2.1 per cent increase in clothing and footwear sales. Food sales fell by 0.1 per cent during the month. "Very low mortgage interest payments and moderate inflation are boosting the purchasing power of a good many people, thereby giving them scope to step up their discretionary spending," said Howard Archer, the chief UK economist at IHS Global. "It may also well be the case that a large number of people are determined to splash out and really enjoy Christmas after enduring a very difficult year."

The year-on-year figures were equally encouraging, with the ONS recording the biggest annual rise in sales since May last year. Sales were up 3.4 per cent in October, against the same month in 2008, although the numbers were flattered by particularly weak trading last year. Despite the encouraging figures, several analysts pointed to what is expected to be a tricky year for retail sales in 2010. "The consumer faces a number of headwinds in 2010, including rising unemployment, higher taxes and larger National Insurance contributions," said Richard Hyman, a strategic retail adviser to Deloitte. "As a result of these factors, we expect retail sales to take a slight fall of 1.5 per cent next year."

OECD warns Britain risks 'debt spiral'

Britain is at growing risk of a "public debt spiral" unless the Government takes "drastic" action to cut the deficit, according to the OECD, world's leading economic institution. The Organisation for Economic Co-operation and Development said that even if Britain reduces its deficit in line with other leading nations, it will still have the rich world's biggest deficit from now until 2017 and potentially beyond, casting serious doubt on its economic credibility. The warning coincided with shock public finance statistics showing that public borrowing in October was 88 times what it was in the same month last year, making it likely that the Chancellor will miss his £175bn borrowing forecast this year.

The double blow is acutely embarrassing for Downing Street, coming ahead of next month's pre-Budget report and only 24 hours after it pledged to create a Bill to halve the deficit within four years and to reduce debt every year for the coming decade. In fact, the OECD predicted in its annual Economic Outlook, Britain's deficit was likely to be even higher next year than this year, at 13.3pc, raising the prospect that the Government could break its own law in its very first year. Britain's deficit will remain higher than any other major country, including even Iceland and Ireland, unless the Government takes far more drastic action to repair it, said the OECD's acting chief economist Jørgen Elmeskov. "Halving the deficit would be a start, but since the UK is starting out from a deficit which is in double figures, one should go further still," he said. "The concern is that there could be a cost spiral - where debt increases, hitting confidence in the market, which pushes up interest rates, and this leads to even higher deficits."

The prospect of interest payments on Britain's rapidly growing debt rising to 12pc of tax revenues has already prompted Standard & Poor's to issue a warning about the security of the UK's credit rating. The OECD said that it expected the total gross debt levels owed by the British Government to rise from below 50pc of GDP in 2007 to 120pc of GDP by 2017. This would be higher than any other G7 economy apart from Japan, whose gross debt would reach an unprecedented 223pc of GDP. The OECD, which predicted that growth in the rich world would recover this year at a "tepid" rate, also forecast that Britain's economy would grow by 1.2pc in 2010, having contracted by 4.7pc this year.

Its UK debt warning came as the Office for National Statistics said that public sector net borrowing in October was £11.4bn - a record for the month. The shortfall, caused by a slump in tax revenues and the increased cost of supporting the unemployed, leaves the deficit almost treble that of last year. October normally shows a surplus as corporation tax receipts arrive. Shadow Chancellor George Osborne said: "Today is a defining moment in the debate about Britain's debt - the moment when we see that Gordon Brown has not just lost control of the public finances but lost the economic argument about the debt crisis.

UK government deficit now increasing at £3bn a week

The Government’s deficit is now increasing at a rate of almost £3 billion a week, it has emerged, in a blow to Gordon Brown. Barely 24 hours after Mr Brown pledged to halve Britain’s record budget deficit within four years, official figures revealed that the Government is due to borrow even more this year than it forecast in the Budget. In a further embarassment for the Prime Minister, the chief economist of the Organisation for Economic Co-operation and Development said that the Fiscal Responsibility Bill unveiled in the Queen’s Speech this week was not ambitious enough to solve Britain’s fiscal problems. The government borrowed some £11.4 billion in October, bringing the total borrowed so far this year to £86.9 billion - the highest running total in history - according to the Office for National Statistics.

The news is particularly embarrassing since October is usually one of the best months of the year for the public finances, since it is when much of the corporate tax receipts arrive in Whitehall. The Conservatives pointed out that the shortfall in October was 88 times more than the same month last year. Economists said it was now all but certain that the Chancellor, Alistair Darling, would miss his borrowing forecast of £175bn this fiscal year. The Government is due to unveil its latest pre-Budget report on December 9, with Mr Darling expected to pledge that as part of its Fiscal Responsibility Bill, it will reduce its deficits every year for the next decade, and to halve the deficit within four years.

In an interview yesterday Mr Brown appeared to concede that Mr Darling may also need to announce further tax rises. "The Chancellor, in the pre-Budget report, will make any announcements that are necessary," he said. Asked to rule out increases above those unveiled in the last Budget, the Prime Minister said: "I'm not going to say that because there's no decision on that." The Paris-based OECD - the Western world’s leading economic authority - yesterday cast doubt on whether Mr Darling's pledge to halve the deficit in four years would be enough. Its acting chief economist, Jørgen Elmeskov, said: "Halving the deficit would be a start, but since the UK is starting out from a deficit which is in double figures, one should go further still." he said. He warned that unless the Government does so, it could be at risk of a "debt spiral", in which it becomes trapped by an ever-increasing burden due to rising interest costs on its deficit.

The OECD said that Britain would have the biggest deficit in the developed world not merely next year and the one after, but all the way until 2017, unless it took "drastic" action to bring it down by a significant margin. George Osborne, the shadow chancellor, said: "Today is a defining moment in the debate about Britain's debt - the moment when we see that Gordon Brown has not just lost control of the public finances but lost the economic argument about the debt crisis. "The OECD said that more ambitious plans to get a grip on the deficit would, as Conservatives have consistently argued, ‘strengthen the recovery.’"

Goldman Shareholders Miffed at Bonuses

Some of the largest shareholders in Goldman Sachs Group Inc. have urged the Wall Street firm to reduce the size of its bonus pool, arguing that it should pass along more of its blockbuster earnings to investors, according to people familiar with the situation. The investors hold tens of millions of shares in Goldman Sachs, which is on track to make the biggest employee payout in the firm's 140-year history.

Their complaints in private conversations with the company and at analyst meetings show how anger over its big-money culture is spilling into the ranks of investors who typically shy away from debates over Wall Street pay. One frustration: Despite record net income and compensation at Goldman as markets rebound and the firm outmuscles weakened rivals for business, analysts expect its 2009 earnings per share to be 22% lower than in 2007 and roughly equal to its 2006 earnings, according to Thomson Financial.

The decline is caused by issuing more than 100 million shares in the past year to bolster Goldman's financial position and capital. The shareholders have said that reining in the bonus pool would deliver an upward jolt to per-share earnings and the share price, according to people familiar with the discussions. Some major Goldman shareholders also are concerned about a little-noticed change in the company's financial statements that increased the firm's total head count by adding temporary employees and consultants. The change reduced per-employee compensation, making it look like Goldman employees earn less than they actually do.

The figure is a lightning rod for criticism of Goldman because its staff is on pace to earn about $717,000 apiece for 2009. Excluding temporary employees and consultants would increase compensation per employee to about $775,000. In the second quarter, Goldman Sachs began including temporary workers and consultants in its overall employee count, according to securities filings. Some shareholders and analysts estimate the company's 31,700-person work force as of Sept. 30 includes about 3,000 nonpermanent employees. Goldman says it wasn't fiddling with the numbers when it added a footnote to its financial statements in July to reflect the change. The firm's reported compensation and benefits pool always included temporary employees and consultants, but they weren't counted in employee totals, according to the New York company.

As a result, Goldman's average of $661,490 per employee in 2007, widely cited as the high-water mark for Wall Street pay, would be smaller on a comparable basis, the company says. It won't disclose the number of temporary workers and consultants currently on Goldman's payroll. In response to criticism that Goldman should share more of its wealth with investors, company spokesman Lucas van Praag says shareholders "have historically been more focused on the absolute return on equity and on book value per share growth" than per-share earnings.

Since going public in 1999, the company has generated a total return of 159%, compared with negative 2.1% for the Standard & Poor's 500-stock index, Mr. van Praag adds. Goldman shares have more than doubled this year, though they were down $4.07 a share, or 2.3%, to $172.83 in trading Thursday on the New York Stock Exchange. The large Goldman shareholders aren't pushing for a huge downsizing of the bonus pool, agreeing with the company that it needs to reward employees for performance. But Goldman should better reward shareholders for this year's rebound, these shareholders contend.

Roger Freeman, an analyst at Barclays Capital, says he has heard from some shareholders who are concerned about how much Goldman delivers to shareholders. "It is certainly an issue, but there are other considerations," he says. "Goldman has a pay-for-performance culture, and if Goldman violates that pact with employees they run the risk of talented people leaving, which wouldn't necessarily be good for shareholders."

Some investors expect Goldman to pay out a smaller percentage of its revenue in the fourth quarter than it did in previous years. "I would be surprised if they came out with a compensation pool this year that is at the level of prior years," says Tom Marsico, founder of Marsico Capital Management LLC, who often talks to Goldman about compensation and capital allocation. His Denver firm held 10.6 million Goldman shares at Sept. 30

Mr. Marsico is less concerned about per-share earnings than other large Goldman shareholders. Over the years, though, he has unsuccessfully encouraged the firm to reward shareholders in other ways, including a special one-time dividend rather than buying back shares. A one-time dividend this year, however, is unlikely because regulators are working on new capital requirements and Goldman and others would need government approval to issue one. "We think the compensation debate is coming across as a populist issue, when to us it is really about how Goldman and other firms can best allocate capital and how pending changes in the regulatory framework may change all this," Mr. Marsico says.

Michael Mayo, an analyst at Calyon Securities, says reducing the size of Goldman's bonus pool could ease scrutiny of the firm while boosting shareholders, including Goldman employees who own between 10% and 15% of the company's shares. "Employees stand to benefit, the government benefits and shareholders benefit," he says. Goldman isn't expected to announce how much it will pay employees for 2009 until the company reports fourth-quarter results in January. Employees are likely to get less cash as a percentage of total compensation but more restricted shares that would vest in the future, in line with Wall Street's response to criticism that old pay practices encouraged risk-taking.

In October 2008, Goldman received $10 billion from the U.S. government as one of the first nine recipients of taxpayer-funded capital injections under the Troubled Asset Relief Program. Goldman repaid the money in June but continues to benefit from government help. For instance, it has the ability to borrow from the Federal Reserve. Goldman and other firms won that access after Bear Stearns Cos. collapsed and was sold to J.P. Morgan Chase & Co.

Goldman had 576.9 million average diluted shares outstanding in the third quarter, up 29% from a year earlier. As of Sept. 30, the five largest Goldman shareholders were AllianceBernstein LP; a Barclays PLC unit; a State Street Corp. unit;, Wellington Management Co.; and Vanguard Group Inc., according to LionShares, which tracks institutional ownership of publicly traded companies. Goldman reported earnings of $8.44 billion for the first nine months of 2009, up 90% from a year earlier. Compensation and benefits jumped 46% to $16.71 billion. That was equivalent to 47% of the company's net revenue of $35.56 billion.

Tax the windfall banking bonuses
by Martin Wolf

Windfall taxes are a ghastly idea. They are a sop to prejudice, a burden on risk-taking and a form of arbitrary confiscation. No sensible person should support them. So why do I now find the idea of a windfall tax on banks so appealing? Well, this time, it really does look different. First, all the institutions making exceptional profits do so because they are beneficiaries of unlimited state insurance for themselves and their counterparties. As Andrew Haldane of the Bank of England argues, the state has "become the last resort financier of the banks".* In the UK, total support amounted to a staggering 74 per cent of gross domestic product. These must be the largest business subsidies ever.

Second, the profits being made today are in large part the fruit of the free money provided by the central bank, an arm of the state. The state is giving the surviving banks a licence to print money. Third, the case for generous subventions is to restore the financial system – and so the economy – to health. It is not to enrich bankers, particularly not those engaged in the sorts of trading activities that destroyed the financial system in the first place. Fourth, ordinary people can accept that risk takers receive huge rewards. But such rewards for those who have been rescued by the state and bear substantial responsibility for the crisis are surely intolerable. What makes them yet more so is that the crisis has devastated the prospects of tens, if not hundreds, of millions of innocents all over the globe. The public finances will be devastated for decades: taxes will be higher and public spending lower. Meanwhile, bankers are about to reap huge rewards. This damages the legitimacy of the market economy.

Fifth, it is hard to argue in favour of exceptional interventions to bail out the financial sector at times of crisis, and also against exceptional interventions to recoup costs when the crisis is past. "Windfall" support should be matched by windfall taxes. Finally, these are genuine windfalls. They are, as George Soros has said, "hidden gifts" from the state. What the state gives, the state is entitled to take back, if it is not used for the state’s purposes. So the question, in my mind, is not whether a windfall tax can be justified but whether it can be designed successfully. All taxes have unintended consequences. One must be particularly careful with this one.

Since the aim of policy is to recapitalise the banks, the tax should not reduce their ability to do so. It would be far better then to impose a tax on contributions made to the bonus pool. There is no public interest in such payments. Since it would be a one-off event, it should not affect incentives (unless banks plan to create systemic crises every few years). If the tax applied to all banks operating within a given jurisdiction, it would not affect competitiveness among them. The case seems strong – even more so if the tax could be implemented across major jurisdictions, simultaneously. Yet windfall taxes cannot contain financial excess, precisely because their goal is not to affect incentives. So what is to be done?

As Mr Haldane notes, we have seen "a progressive rise in banking risk and an accompanying widening and deepening of the state safety net". As the liabilities of the banks have become ever more socialised and so equity cushions have become increasingly redundant, the incentive for both limited liability shareholders and employees to game the taxpayer has risen greatly. It is rational for banks to choose risky strategies because they take the upside and taxpayers much of the downside. Over the past half century, UK bank capital has remained at between 3 per cent and 5 per cent of assets, these assets have risen tenfold, relative to GDP, and returns on equity have averaged 20 per cent. Such high returns, in an established industry, must mean either high barriers to entry or excessive risk-taking. The former are undesirable and the latter terrifying, particularly in view of the huge rise in the state’s exposure to the risks.

We will never have a better opportunity than now to redress the deteriorating terms of trade between the banks and the state. A big part of the solution must be to shift incentives. The more credible are the pre-announced limits on support from government, the more effective will be the changes in incentives inside banks, and vice versa. The less we are able to shift these incentives, the more important it will be to impose heavy regulation. The combination of today’s incentives with today’s safety nets and yesterday’s "light touch" regulation was devastating. Yet, regardless of the success of reforms of incentives in – and regulation of – the financial sector, it is reasonable to recoup not only the direct fiscal costs of saving banks but even some of the wider fiscal costs of the crisis. The time has come for some carefully judged populism. A one-off windfall tax on bonuses would make the pain ahead for society so very much more bearable. Try it: millions will love it.

Philanthropy and bank bashing
by Gillian Tett

What exactly was going through the brain of Lloyd Blankfein, head of Goldman Sachs, this week when the bank announced a $500m initiative to help small US businesses? At first glance, the answer might seem obvious. This year Goldman has faced a barrage of political attack, not merely for its part in stoking the credit bubble but also for having made fat profits as that bubble imploded. The fact Goldman is setting aside $500m – or some 3 per cent of its planned bonus pool this year – might be interpreted as an effort to quell the current bank-bashing and consign it to the past. Not for nothing did Mr Blankein say "sorry" for previous mistakes by Goldmans (and others).

While that logic might explain part of Blankfein’s motives, it is almost certainly not the whole tale. For, insofar as the move was really triggered by philanthropy – and, as my colleague Francesco Guerrera wrote on Thursday, it will also help the bank meet government rules – it may not be the current round of banker-bashing that is worrying the bank. Goldman is (in)famous for trying to be ahead of the curve. The really interesting political economy issue that haunts finance now is not the attacks that Goldman (and other banks) have suffered in 2009 – but the question of what could await them in 2010, 2011, 2012 or beyond.

The issue at stake is timing. Recent months have seen a great deal of debate in political circles about the fact that the taxpayer is "footing the bill" for the banking woes. In part that rhetoric has been wrong: thus far the taxpayer has not had to "foot the bill" in a fiscal sense, because governments have not yet tried to confront the rising tide of debt. In most of the Western world, 2009 has been a year of fiscal expansion. Just think, to name one example, of those cash for clunkers schemes. While we know some of the "bill" from the bank crisis ($2,800bn of toxic assets, say) and the impact on the economy (several percentage points of lost gross domestic product), taxpayers have not yet seen their "bill". That will only land in the next few years, when governments hike taxes and slash public spending (or, if they have refused to do this, they face a bond crisis).

If you are an optimist – as investment banking salesmen are paid to be – you can argue that this future bill will not be so painful. By 2011 or 2012, the global economy may be booming and if the fiscal noose tightens gradually, voters may simply adjust, not revolt. Japan has lived with economic stagnation for years without suffering from riots. However, it is very easy to imagine more alarmist scenarios. I think the chance of a real economic boom is relatively low, given the scale of likely future deleveraging. I also fear that the government bond markets will not remain quiet. Moreover, in fiscal policy some crucial "tipping points" might emerge to spark public anger.

Perhaps that will occur when income taxes are hiked above 50 per cent. Or maybe when hospital budgets are cut, or military spending slashed. Either way, the potential list is long. While that might cause political instability (which, of course, would be bad for bond markets) it might trigger a renewed, vitriolic round of bank-bashing – particularly if voters in 2011 or 2012 know that 2010 was a year when banks paid out more, massive bonuses. No wonder that some financial officials and politicians are frantically pleading with bankers behind closed doors to show more restraint in their current bonus round. "Don’t the bankers realise what could be coming?" I heard one senior western finance official tell a room full of bankers this week, as he argued – with passion and a sense of desperation – that it would be a mistake for banks to pay big bonuses.

Can Goldman’s $500m programme protect the bank against that political risk? On paper, the target of its largesse certainly looks politically savvy: small business funding is a huge political headache in the US because of its link with unemployment. The fact remains that $500m is still just 3 per cent of the bank’s bonus pool and even a non-banker can see that is a small sum. As hedging strategies go, this remains far from sure to work. Indeed, the only thing that is crystal clear is that Goldman’s competitors cannot afford any Schadenfreude. As I said, the risk remains that the backlash today is just a foretaste of what is to come – for bankers across the street (and City).

ECB President Trichet warns on bank bonuses

Jean-Claude Trichet, European Central Bank president, has issued his strongest warning yet that banks must keep pay and bonuses "contained" and prepare for the withdrawal of emergency support action. Striking a noticeably stiffer tone than previously, Mr Trichet told a Frankfurt conference that voters would not accept taxpayers’ funds being deployed again on the same scale to rescue banks. His comments reflected ECB fears that financial market improvements will encourage complacency – reducing the impetus for regulatory and supervisory reform. "I understand that the mood in the financial system is one of relief. But as of today, it is too early to declare the crisis over," Mr Trichet said.

The ECB president quoted Goethe – Frankfurt’s most famous son – in a warning about the need for self-restraint: "If I wanted to lavishly let myself go, I could well destroy myself and my environment." Addressing Germany’s financial elite at the 19th Frankfurt European Banking Congress, Mr Trichet said: "Compensation and bonuses must remain contained. Otherwise, we would take risks that Goethe already described." He added: "Profits earned should be used – as a priority – to build capital and reserves, rather than be paid out as dividends or excessive compensation." Although the ECB is cautious about the eurozone’s economic outlook, improvements in financial markets have brought it significantly closer to unwinding the exceptional policy steps taken after the collapse of Lehman Brothers investment bank last year.

Mr Trichet said the ECB would move gradually but warned that "the financial system and individual institutions within it must act now to ensure that a future removal of central bank support can be managed without painful ‘withdrawal symptoms’." As a first step, the ECB is expected to announce that next month’s offer of unlimited one-year liquidity to eurozone banks will be the last. Mr Trichet also stepped up pressure on banks to increase lending to the real economy as "public support has been provided for this purpose, and the strengthened balance sheets will allow them to lend". The ECB believes the sharp slowdown in eurozone lending largely reflects weak demand – rather than a widespread "credit crunch". But Mr Trichet said "it will be particularly important that banks intensify their efforts to expand their supply of loans once loan demand picks up".

House Attacks Fed, Treasury

Political frustration over the rescue of Wall Street and high unemployment erupted in the House Thursday, with one committee threatening to impose tighter scrutiny on the Federal Reserve and another trading verbal insults with Treasury Secretary Timothy Geithner. The House Financial Services Committee voted, 43-26, to approve a measure sponsored by Texas Republican Ron Paul, vociferously opposed by the Fed, that would direct the congressional Government Accountability Office to expand its audits of the Fed to include decisions about interest rates and lending to individual banks. The Fed says the provision threatens its ability to make monetary policy without political interference.

The vote was the latest blow to the central bank, which has been become a lightning rod for politicians responding to popular anger that Wall Street was bailed out while the public wasn't. The Fed faces a stinging backlash from legislators from both parties who argue that has too much power and too little oversight. On Thursday, the Senate Banking Committee began debating legislation that would largely remove the Fed from bank supervision over the objections of the Fed and the Obama administration.

The Fed audit provision was added to pending legislation on financial regulation that the committee's chairman, Barney Frank, a Massachusetts Democrat, had planned to put to a vote Thursday. But he abruptly announced late in the afternoon that the bill wouldn't move ahead until after Thanksgiving. The reason: Ten members of the Congressional Black Caucus on the committee said they would oppose the bill to protest a lack of action to address the economic pain borne by their constituents. Although the economy appears to be growing again, lawmakers face increasing pressure in their districts to do more to boost growth and address an unemployment rate now at 10.2% and expected to rise.

Glum views on the economy sparked a retreat from stocks and some commodities, as investors moved to the safety of government debt. The Dow Jones Industrial Average fell 93.87 points to 10332.44. At the Joint Economic Committee, a couple of House Republicans called for the resignation of Mr. Geithner, who, as president of the Federal Reserve Bank of New York, played a major role in last fall's moves to prevent the collapse of the financial system. "The public has lost all confidence in your ability to do the job," said Rep. Kevin Brady, Republican of Texas. Mr. Geithner, in an unusual public display of pique, fired back. "What I can't take responsibility is for the legacy of crises you've bequeathed this country," he told Mr. Brady.

Although several Democrats defended Mr. Geithner at the hearing, some liberal Democrats have been complaining that the Obama administration isn't doing enough to combat unemployment. Rep. Peter DeFazio (D., Ore.) called on Mr. Geithner to resign this week, and said in an interview that Mr. Geithner is too close to Wall Street. "Quite frankly, all the gambling on Wall Street is doing nothing to put people back to work in America and rebuild our economy," the Oregon Democrat said.

One issue that has dogged Mr. Geithner is the rescue of American International Group Inc. last fall. A government oversight report this week charged that the New York Fed caved into demands from Goldman Sachs Group Inc. and other big banks and paid them in full for deals they had made with the insurer. Mr. Geithner said Thursday that the government lacked powers it needed to handle the collapse of a financial company that wasn't legally organized as a bank. "Coming into AIG we had, basically, duct tape and string," he said. The legislation pending in Congress would give the government new powers to manage such a situation.

Mr. Geithner's job status doesn't appear to be in jeopardy and several Democrats leapt to his defense. "He was handed an awful deck of cards when he walked into the job, and he's doing the best he can," said Sen. Charles Schumer (D., N.Y.) in an interview. "I think many Democrats share my views."

Mr. Paul, author of a new best-seller "End the Fed," long has been a critic of the Fed. His economic views make him an outlier in Congress, but his attacks on the Fed have resonated in Congress and with the public.
The Paul provision, and the legislation to which it is attached, would have to clear the full House and Senate before becoming law. Though many lawmakers insist they won't do anything to compromise the Fed's independence on monetary policy, the provision's momentum is substantial. It could be diluted before any bill reaches the president. "Everybody would like to beat up on the Fed and make them the bad guy," said Rep. Melvin Watt (D., N.C.), who opposed Mr. Paul's measure. He said audits would "substantially castrate the Fed so it cannot do what it was set up to do."

Fed Chairman Ben Bernanke has crisscrossed the Capitol in recent weeks, attempting to fend off legislation that would curtail the Fed's power or independence. Lawmakers with whom he has met said he has reminded them how close the U.S. came to economic catastrophe last year and maintained that the Fed's actions were critical to bringing the economy back to growth. But Mr. Bernanke faced a skeptical audience. Some lawmakers told him Americans are angry and want more oversight; others said the crisis demanded a rethinking of the U.S. approach to financial regulation.

"What he says is that at that point in time, with our economy literally ready to tip over the edge, he did a series of things he thought were absolutely necessary," said Sen. Mike Johanns, a Nebraska Republican. "He was trying to convey that this point in time was enormously serious, and the country was about ready to lock up from an economic standpoint. He just says, 'Look, I did what I thought I had to to keep the country going,'" he said.

In an interview, former Fed Chairman Alan Greenspan said it would be "a major loss to the country if the Fed were incapable of running an independent monetary policy. If you have the GAO, after the fact, offering its opinions on whether a certain monetary policy action is correct or incorrect, the active deliberations that are so critical to building a meaningful consensus at the FOMC will begin to become unhelpfully cautious." Mr. Paul maintained that his amendment wouldn't hinder monetary policy, but instead remove a veil of secrecy at the central bank that's unique within U.S. government. At the Fed, "there's plenty of political influence going on now -- presidential politics, influence by Goldman Sachs and the banking industry," he said. "It's all done in secret."

Congressional auditors have been blocked from reviewing the Fed's monetary policy operations, its loans to foreign governments and direct lending to banks since 1978, when a law was passed to shield the central bank from politics. Auditors already have access to the Fed's operations outside of monetary policy, including bank supervision and the special loan facilities created to rescue specific institutions, such as AIG and Bear Stearns Cos.

GAO audits could publicly reveal reams of information that now remain private, sometimes indefinitely. The Fed doesn't identify banks to whom it lends directly for fear of sparking a disruptive run on the bank. It has suggested that it might be willing to release that information after a lag. The Fed in the past has resisted calls to release information, only to relent. In the 1990s, for instance, after pressure from Congress, the Fed began releasing transcripts of its interest-rate deliberations after a five year lag. Mr. Paul's proposal would delay GAO access to Fed decisions for six months. A companion Senate measure has drawn support from about a third of that chamber.

"If there's anything worse than a secret Federal Reserve, it's Congress controlling it," said Sen. Jim DeMint, Republican of South Carolina. "But I do think that there's a wide majority of Americans who want to know what the Federal Reserve is doing and to make sure that it's achieving its primary purpose, which is to protect the value of our dollar."

Black Caucus Stalls Finance Overhaul

In one of the clearest examples of how the weak economy is overtaking Obama administration priorities, the Congressional Black Caucus forced the House to shelve its revamp of financial-sector regulation for two weeks. According to House Financial Services Committee Chairman Barney Frank (D., Mass.), members of the caucus revolted on the grounds that their constituencies weren't allowed sufficient participation in Treasury and Federal Deposit Insurance Corp. programs, such as the Troubled Asset Relief Program or FDIC oversight of failed bank assets.

They also complained more broadly that the administration wasn't doing enough to create jobs for low-income people or preserve minority-owned institutions such as radio stations, lending companies and jobs programs, a person familiar with the issue said. There are 10 members of the Congressional Black Caucus on Mr. Frank's committee, and their promised bloc vote against the bill could have torpedoed it. The caucus's action wasn't directed at the overhaul, but at the administration's broader response to the economy and job market. It has the practical effect of derailing the effort, at least until after Thanksgiving.

Congressional Black Caucus members said little after the vote was abruptly halted. "The recession has created a unique systemic risk that threatens all parts of the African-American community, including the poor and middle class," Rep. Maxine Waters (D., Calif.) said in a written statement. "I have always been committed to addressing that risk and will continue to do so. This is a critical issue for my constituents." Her office declined to elaborate. The administration's problems with more-liberal lawmakers have been brewing for weeks, based in part on a perception that the new president has made too many concessions to moderate Democrats on policies from health care to Afghanistan.

On Monday, Treasury Secretary Timothy Geithner and White House Chief of Staff Rahm Emmanuel traveled to Capitol Hill for an 8 p.m. meeting with Mr. Frank and members of the black caucus. Mr. Frank said White House officials had been hopeful they could work out a deal by the close of business Thursday. He spent the day shuttling between his panel's votes on financial regulation and a meeting with FDIC officials and caucus members.

Later in the day, however, he was told the black caucus wouldn't vote for the bill because their concerns weren't met, raising the possibility that the administration's initiative to overhaul financial-market rules could be scuttled before it reached the House floor. "They want to continue to have some bargaining power with the administration," Mr. Frank said. Mr. Frank said he was optimistic a deal could be reached when the committee votes again after Thanksgiving. "We believe we will have agreement," he said.

Panel Votes to Broaden Oversight of the Fed

In a display of populist anger toward the Federal Reserve, a House panel voted on Thursday to let Congress carry out sweeping new oversights of the central bank’s policy decisions and operations. The House Financial Services Committee approved a measure proposed by Representative Ron Paul of Texas that would allow Congress to order audits of all the Fed’s lending programs as well as of its basic decisions to set monetary policy by raising or lowering interest rates.

If the measure becomes law, it would expose the Federal Reserve to far more political pressure than it has faced for decades. Fed officials have adamantly opposed the measure, saying it would undermine the central bank’s political independence and gravely threaten its credibility as a bulwark against inflation. The vote on Thursday occurred despite the opposition of Representative Barney Frank, Democrat of Massachusetts, who had wanted to shield the Fed’s decisions on monetary policy from political pressures.

Mr. Paul, a libertarian Republican who has called for abolishing the Fed entirely, has introduced a version of his bill in every session of Congress since the early 1980s and never made any progress. But the Fed’s trillion-dollar efforts to bail out major banks and rescue the financial system provoked a popular firestorm that ignited both right-wing Republicans and left-wing Democrats. Mr. Paul’s amendment would instruct the Government Accountability Office, the investigative arm of Congress, to carry out audits of all the Fed’s operations. Those include an array of emergency lending programs, bailouts of giant financial institutions, dealings with foreign central banks and the central bank’s efforts to drive down interest rates by intervening in bond markets.

Mr. Frank had already agreed that the G.A.O. should be authorized to audit all of the Fed’s rescue programs, but he had wanted to wall off the Fed’s more basic job of setting interest rates to steer the economy. Mr. Paul’s bill would abolish a longstanding exemption that shielded the Fed from Congressional audits of its monetary policy. Supporters of the Fed’s independence have argued the shield provided crucial insulation from political pressure, which would make it much harder for Fed officials to take unpopular action aimed at heading off inflation.

"This is a political warning shot," said Vincent R. Reinhart, a former top Fed official who is now a senior fellow at the American Enterprise Institute. "It says that Congress has a mechanism to opine about monetary policy. The fear is that every time there’s a threat of higher interest rates, someone in Congress will ask for a study of the costs of higher interest rates."

The Fed was not the only institution exposed to political wrath on Thursday. Timothy F. Geithner, the Treasury secretary, came under fire from both conservative Republicans and liberal Democrats at a hearing of the Joint Economic Committee. Representative Kevin Brady, Republican of Texas, told Mr. Geithner he should resign. At the House Financial Services Committee, which was working on a sweeping bill to overhaul financial regulation, Mr. Frank had argued that Mr. Paul’s amendment went too far and would damage the Fed’s credibility.

Fed officials have argued that global investors would immediately become more skeptical about the central bank’s willingness to fight inflation by raising interest rates, which in turn would force the Fed to raise interest rates higher to accomplish it owns goals to keep prices stable. The result, they have warned, could be both higher inflation and slower growth. But Mr. Paul and his supporters argued that the measure would do nothing to undermine the central bank’s independence. Its only purpose was to force the Fed to be more transparent and accountable to the public. In a surprising display of political rebellion, about half the Democrats present and all the Republicans voted for Mr. Paul’s bill instead of a compromise measure drafted by Representative Mel Watt, Democrat of North Carolina.

In a related move on Thursday, the House Financial Services Committee also approved an amendment by Representative Paul E. Kanjorski, Democrat of Pennsylvania, that would give the government new power to restrict financial institutions deemed too big to fail. But Mr. Frank surprised some of his colleagues by postponing a vote on the overall bill until after Thanksgiving. Mr. Frank said he wanted time to address concerns raised by members of the Congressional Black Caucus.

Auditing the central bank: a jolly good thing! (How about the ECB?)
by Willem Buiter

What is so important about H.R. 1207: the Federal Reserve Transparency Act of 2009 aka the ‘Audit the Fed’ bill? This bill "To amend title 31, United States Code, to reform the manner in which the Board of Governors of the Federal Reserve System is audited by the Comptroller General of the United States and the manner in which such audits are reported, and for other purposes." may not sound terribly exciting, but in addition to making the Fed accountable for its quasi-fiscal activities, it could well set an important precedent for the enhanced accountability of operationally independent central banks everywhere.

The Finance Committee of the US House of Representatives has just passed this bill, which is an amendment sponsored by Representatives Ron Paul (Republican) and Alan Grayson (Democrat) to Representative Barney Frank’s HR 3996, the "Financial Stability Improvement Act of 2009?. The amendment allows the US Government Accountability Office to conduct a wide-ranging audit of the financial activities of the Federal Reserve Board. Specifically (and quoting from the RonPaul.com website):

The Paul/Grayson amendment:
Removes the blanket restrictions on GAO audits of the Fed
Allows audit of every item on the Fed’s balance sheet, all credit facilities, all securities purchase programs, etc.
Retains limited audit exemption on unreleased transcripts and minutes
Sets 180-day time lag before details of Fed’s market actions may be released
States that nothing in the amendment shall be construed as interference in or dictation of monetary policy by Congress or the GAO
This is the first time an external agency will be able to audit the Fed’s financial arrangements with foreign central banks and with major US banks and other financial institutions, such as AIG.

There are times one has strange company when supporting a worthy cause. Support for extending the GAO’s mandate came among others from the usual army of Fed bashers, led in the Congress by Representative Ron Paul (one of the co-sponsors of the measure), and by a motley crew of paranoid conspiracy theorists of the Lyndon LaRouche variety, who accuse the Fed of being behind every evil financial deed committed or suspected of having been committed, and may well believe it is a front for the House of Windsor or the Elders of Zion. Well, I’ll just have to hold my nose and remind myself that even a broken clock points to the right time twice a day. A comprehensive independent audit of the Fed’s use of what is, in the final analysis, public money and therefore tax payers’ money is long overdue. This is a major victory for democracy and the public’s right to know what those to whom certain public functions have been delegated and entrusted have been doing with the taxpayers’ money.

Let’s face it, nobody and no institution likes being at the receiving end of greater openness, transparency and accountability. Accountability is a noble cause when you want to impose it on others, but an infernal nuisance when you are subject to it. The amendment that was passed expressly forbids the GAO or the Congress from interfering with the Fed’s independence in managing monetary policy, that is, in setting interest rates and providing liquidity support to markets and institutions. And there is no reason why even thorough, indeed intrusive scrutiny of the Fed’s financial transactions would interfere in any way with the independent pursuit of its monetary mandate. Those who argue otherwise are merely asserting that the wrong set of people - a bunch of shrinking violets - have been appointed to the Federal Reserve Board.

What’s good for the Fed and for American democracy is equally important for the European Central Bank and European democracy or for the Bank of England and British democracy. The ECB has been running a massive cash-for-clunkers scheme for Euro Area banks since August 9, 2007 (perhaps it should be referred to as the ECB’s ‘cash-for-clankers’ or ‘cash for bunkers’ scheme). It has done this by accepting as collateral in repos and other collateralised loan transactions conducted with eligible Eurosystem counterparties by the 16 national central banks (NCB) that together with the ECB make up the Eurosystem. The terms on which this collateral was accepted by the NCBs are not in the public domain in the case when this collateral was illiquid. In the absence of an acceptable market price guide to valuing the collateral, the ECB specifies that a technical price is used, based on internal models and other valuation methods that are private to the Fed.

Despite repeated requests by me to members of the Executive Board of the ECB and to Governors of NCBs belonging to the Eurosystem, neither the internal models used to value illiquid collateral, nor the actual valuations assigned to specific securities offered as collateral have been put in the public domain. This amounts to an outrageous and arrogant denial of the Eurosystem’s duty to account to the European Parliament and to the European citizens at large for its use of tax payers’ money. We have good reasons to suspect that the terms on which the Eurosystem has made collateralised funds available to the Euro Area banks (including many subsidiaries of banks headquartered outside the Euro Area) have included a significant quasi-fiscal subsidy. Banks all over the Euro Area, notably Spanish, Dutch and Irish banks, but also, before the fall, Euro Area subsidiaries of Lehman Brothers and the Icelandic banks, bundled and wrapped large amounts of securities they could not use as collateral anywhere else, and presented the resulting rubbish to the Euro Area NCBs as collateral for central bank liquidity.

Even if such over-valuation of rubbish collateral is the right thing to do, from the perspective of the greater public good of systemic financial stability, there must be transparency about the magnitude of the ex-ante and ex-post quasi-fiscal transfers involved. The ECB is the custodian of public funds. In this fiduciary capacity, it owes a duty of care to the European citizens. And whether or not it fulfils its fiduciary duties appropriately cannot be based on blind faith and unquestioning trust in the inherent goodness and wisdom of the ECB. It is time for a detailed and comprehensive independent audit of the ECB’s financial transactions since the beginning of the crisis. This should include a close examination of the precise terms and conditions, including valuations of illiquid collateral, on which liquidity support, including enhanced (credit) liquidity support has been made available to the Euro Area banks by the NCBs of the Eurosystem.

I want to be clear about what I mean by an independent audit of the ECB and the Eurosystem. The ECB reports on its finances and has its annual accounts scrutinized by outside auditors (as per Aricle 109 B (3) EC Treaty and Articles 26 and 27, ESCB Treaty). This makes sure things add up and there is no evidence of fraud and malfeasance. The ECB is not subject to the full scrutiny of the European Court of Auditors, the panel of financial experts that examines the revenue, expenditures, management, and overall efficiency of the European Union’s bureaucracy. The Court of Auditors only examines the ‘operational efficiency’ of the management of the ECB (Article 27.2 ESCB Statute) and has thus far used a very narrow interpretation of the concept of ‘operational efficiency’. Clearly, the job of auditing the ECB for the proper use of its financial resources cannot be performed by an internal unit of the ECB itself, such as its Internal Audit Directorate or its Audit Committee.

Following the precedent set by the 2003 decision of the European Court of Justice in the OLAF case brought by the European Commission against the ECB (where the ECJ rejected the ECB’s claim that it had the right to set up its own independent anti-fraud regime and that it did not fall under the regime established by the European Regulation concerning investigations conducted by the European Anti-Fraud Office (OLAF)), I would deepen and broaden the mandate of the European Court of Auditors as regards its audit of the ECB’s accounts. There is no reasonable argument that confidentiality concerns and the defense of its monetary policy independence would preclude the same kind of scrutiny of the accounts of the ECB by the Court of Auditors that is granted the US GAO in the Federal Reserve Transparency Act. The results of this enhanced investigation/audit of the accounts of the ECB by the Court of Auditors should, with due regard for reasonable confidentiality concerns, be in the public domain. This kind of detailed and comprehensive independent audit should become a regular part of the reporting and accountability mechanism that underpins the ECB’s independence. The time to start is now. I hope the European Commission and the European Parliament will press the issue.

Deutsche Bank Life Insurance Fund in Hot Water

Two Deutsche Bank funds were designed to profit from premature deaths in the US by buying up life insurance policies. But investors have seen precious little return on their investment. Angry customers are accusing the bank of fraud. Gerhard Strate, a well-respected lawyer based in Hamburg, has seen a lot of things over the years. But he still has a hard time believing the story of the Deutsche Bank funds db Kompass Life 1 and 2, calling it "unbelievable" and "absurd." The closed-end funds buy life insurance policies from Americans and assume responsibility for paying their future premiums. When the original policy-holder dies, the entire payout goes to the fund. It is like short-selling US life expectancy.

Deutsche Bank collected some €500,000 ($750,000) from customers for its macabre money-making scheme. But the fund quickly turned into a mega-flop. So far, not one investor has received even a single dividend payment and some may lose their entire principal. Now, Strate has filed a criminal complaint with public prosecutors in Frankfurt on behalf of one of those who invested in the fund. A lawyer from Munich has also announced his intention of filing a complaint of his own, believed to be on behalf of dozens of clients. He is also preparing claims for damages.

There is cause to suspect "that from the very beginning, the promised dividends were not achievable using any realistic suppositions," Strate wrote in his complaint. In addition, he says, investors into the two funds were not adequately informed about one aspect of the scheme's structure: that both funds invest to a large degree in the same policies, thus "making risk management practically impossible." Thus, he argues, the funds may have crossed the line into fraud or at least breach of trust. "Finding out exactly which is a job for the public prosecutors," Strate said.

Karl-Georg von Ferber, a lawyer who represents an association of investors, points to the db Kompass Life 1 annual report for 2006. The policies that had been purchased by the fund are listed in detail. Only two of them had an estimated policy period of four years or less with many listed as not maturing for 10 years or more. Nevertheless, the report promised investors a return of 7.5 percent per year beginning already in 2007. "The way I see it, investors were knowingly misinformed," Ferber says. Deutsche Bank has refused to comment on the criminal complaints. The bank explains away the funds' non-performance by pointing to the recent increase in US life expectancy. As a result, they wrote to investors, "fewer policies matured than expected." Mortality tables, upon which the funds are based, have changed since 2005, the bank explained.

A Deutsche Bank spokesperson rejected accusations that the bank has misled investors. The bank, the spokesperson said, "has always accurately communicated the current situation in the business covered by the funds." Forecasts of life expectancies could not be seen as "absolute numbers" to be used to calculate the cash-flow situation, the bank said. Instead, the bank calculates probabilities for premature or delayed deaths. Nevertheless, the bank -- in the interest of "fairness" -- recently made the angry investors an offer: Should they wish to pull their money out of the funds immediately, Deutsche Bank will grant them 80 percent of their original investment. The funds' rules call for money to stay put until 2015. The offer deadline expires in just a few days. But the investor represented by Strate does not intend "to allow the bank to get away so cheaply."

'Lost Decade' Feared for British Economy

Britain may finally be emerging from recession, but many analysts warn that it is a false dawn. In fact, they argue, the economy here is so ravaged by growing debts and ruined banks that it could well be following in the steps of Japan’s lost decade of the 1990s. The parallels are eerie: Like Japan, Britain enjoyed more than a decade of booming growth, fed by aggressive bank lending and real estate investments. Haunted by the comparison, policy makers have been extra aggressive in using fiscal and monetary levers in hope of preventing the stagnation and banking stasis that plagued Japan for so many years.

Some economic indicators over the last week have been positive: an uptick in retail sales, fewer jobs lost and an export revival. Yet analysts say they may well turn out to be teasers that cloak deeper, more structural flaws in the economy. In addition to rising debt, the tax base is collapsing and the crippled banking industry has yet to show it can generate profit by lending to companies.

"We expect 1 percent growth next year and 0.7 percent in 2011," said Douglas McWilliams of the Center for Economic and Business Research in London. "Technically, it’s a recovery — but it’s a very weak economy indeed." Comparisons with Japan have been made in the United States as well, but some analysts say they think the more appropriate analogy is Britain, given the similarly pronounced contribution of the banking industry to their respective economies.

The prospect of a period of Japan-like stagnation in Britain was publicly aired last month by a senior member of the monetary policy committee of the Bank of England, Adam S. Posen, who was appointed in June. An American and a senior fellow at the Peterson Institute for International Economics in Washington, Mr. Posen was speaking as an outside expert on Japan’s lost decade. He noted that his views were his alone and not those of the bank.

But they carry the weight of one of the decision makers at the central bank, which has been buying billions of pounds worth of government bonds, known as gilts, to inject liquidity into the economy, a policy called quantitative easing. "The United Kingdom has an uncomfortable parallel with the Japanese financial system when the Japanese economy began to recover in the mid-1990s and was unable to sustain it," Mr. Posen said in his speech.

While defending the quantitative easing as necessary and noninflationary, Mr. Posen pointed out that the Bank of England’s huge purchases of gilts — it now owns 30 percent of those outstanding — is in itself a consequence of the British financial system’s inadequacy in providing credit to businesses through the issuance of corporate bonds. In another similarity to Japan, the capitalization of Britain’s private-sector bond market as a proportion of gross domestic product is very low — 0.16 percent, the smallest among the Group of 7 economies and well behind the 1.2 percent in the United States.

For a financial system heralded as one of the world’s most sophisticated, the statistic is eye-opening. It raises the possibility that credit-starved companies, dependent on still-wobbly British banks, may not get the capital they need. That potentially could bring about a double-dip recession or stagnation. Mr. McWilliams, of the Center for Economic and Business Research, forecast that bank lending to companies would decrease over the next two years.

Mr. Posen argued that the Bank of England’s purchases of gilts were unavoidable because the bank needed to bring liquidity to the private bond market. But a growing number of bearish analysts view the bank’s buying spree as perilous to British public finances.

The severity of the problem was underlined this week when the government disclosed an £11 billion ($18.3 billion) borrowing figure for October, which brought the half-year tally to £86.9 billion, the highest level since public records began in 1946. That makes it almost certain that the government’s forecast of £175 billion of borrowing for next year will be exceeded. It would produce a budget deficit of about 13 percent of G.D.P., nearly twice the average in the euro zone.

Simon White, a partner at Variant Perception, a London research firm that caters to hedge funds and wealthy individuals, takes an especially dire view. In a note to clients this week, Variant broached the prospect of a debt or currency crisis as the collapsing tax base — too dependent on real estate, financial companies and the highly taxed rich — leaves the government gasping for revenue but unable to raise taxes without destroying growth.

Taken together with the already high levels of spending, the result is a deficit that grows even beyond 13 percent of G.D.P., further harming the country’s fragile creditworthiness. Both Fitch and Standard & Poor’s view the British economy as the most vulnerable to a downgrade out of the 20 or so countries that carry a triple-A rating. The Bank of England has already spent about £200 billion, or $330 billion, buying British bonds, an amount equivalent to 14 percent of annual G.D.P. Once it stops doing so, interest rates are expected to rise immediately, driving down bond prices. That could prompt already skittish foreign investors, who hold more than 30 percent of government paper, to sell.

To be sure, such an outlook is based on the premise that British politicians will be like their counterparts in Japan in the 1990s and not have the political will to tackle these economic problems. Prime Minister Gordon Brown, whose thin hope of a victory in next spring’s general election rests upon a bankable recovery, has declared a "go for growth" political strategy. The Conservative Party has staked its legitimacy on decreasing debt.

But it has not detailed its program, and some fear that the next government will have little time to get its house in order. "The likelihood of a debt and sterling crisis is just not factored in," Mr. White said. On average, these events have occurred every 15 years since 1947, with the last one in 1992. "If this gets out of control," he said, "it will flip very quickly."

November 19 2009: Risk versus the US dollar

2009-11-19T13:30:00.002-05:00

Detroit Publishing Co. Fire and Ice 1900
Car ferry Michigan Central turning in ice, Detroit River

Ilargi: If and when the Federal Reserve moves out of the mortgage backed securities field -a move expected in the first quarter of 2010-, will private investors step in? Well, why should they? What profit can they expect to reap? US housing prices have been kept artificially high for at least the past two years (if not the past 70) by the combination of the Fed's recent $1.25 trillion MBS purchases and the aggressive securitization policies of Fannie Mae, Freddie Mac and the FHA/Ginnie Mae team.

But this can't go on forever. As the Washington Post says, the government has lost its "huge federal gamble on the politically popular cause of homeownership". And the administration may try to paint rosy and green pictures of an economic recovery, and the stocks markets may seem to be doing relatively well, but none of it means a thing with the housing market in a death spiral.

Now that Washington has lost that bet (a crucial admission for the WaPo, by the way), which investors will still be gullible enough in 2010 to buy securities based on grossly overvalued properties?

The Wall Street Journal warns of a double dip in housing. Color me blind, but when did the first dip end? President Obama also warns of a double dip, this time of the recession in whole US economy. And this time, color me obstinate, but I don't buy the numbers that supposedly show an end to the recession, or the first dip of it. I see trillions of dollars in lipstick applied to dead industries.

You can't end recessions or depressions by borrowing money from one neighbor and handing it to the next. That's not even shoddy accounting, hey it's not even fraud for that matter, it's simply nonsense.

Perhaps if some if the money would have been used in fields that produce actual products, if it would have provided useful jobs for Americans, then perhaps it would have alleviated some of the misery. Banks, though, do neither, and still they are the sole recipients of bail-out money so far. Yes, even of what went to Detroit or home-buyers, just follow the money.

And so, starting January 1st, some 30,000 Americans every day, or 1 million per month, will start losing ALL benefits, even those just agreed on last week by Congress, unless yet another plan is devised. And this will happen against the backdrop of $30+ billion in year end bankers' bonuses. $10 million for one guy, nothing for the other. Scrooge ain't dead, he's alive and well at 85 Broad Street.

And no relief in sight. Unemployment keeps seeping upwards, and the other pillar of the economy, housing, looks ever closer to its terminal breath. Oh, someone will always build a home somewhere, but that does not an industry make. The most blatant sign of pain this time around comes from a graph on multi-unit housing starts, a category routinely filed under "commercial real estate", which shows the lowest number on record since reporting started in 1958.

The lowest number on record! In case you hadn't realized it yet, the US population today is not that far shy of having doubled since the 1950's. Twice as many people, but less family housing is built.

Talking about commercial real estate, it should be obvious who everyone's betting against today. Regional banks, both big and small, have, in relative terms, much larger exposure to CRE than their national-sized brethren, as this Moody's graph shows:

The FDIC may feel well playing its part in the overall US government opacity (does anyone even remember the promises of greater transparency?), but hundreds of banks that Sheila Bair and co. have refused to tackle until now will be due to meet their makers regardless in the -very- near future.

And if you're still among the faithful believers despite what goes on in employment, housing and commercial real estate, here are a few things you might want to pay attention to.

House Rep. Peter Defazio claims a growing consensus among Democrats to call for the head of Treasury Secretary Tim Geithner. It's safe to assume that Larry Summers would have to go as well. Geithner's future may depend on the upcoming December unemployment summit in Washington.

Given the fact that the summit is at least one year late, that the public money spread around Wall Street can't be spent a second time, and that Geithner insists on using the remaining TARP funds for something other than jobs, it could be an interesting meeting. But in view of the control the Obama spin team has exercised so far, hopes for a revolt by their own party may be idle. And besides, what good would it do? Most important posts would still be in Goldman, JPM, Citi and Morgan Stanley hands.

More interestingly, perhaps, are two reports this week, in which financial giants Goldman Sachs and Société Générale, separate from each other, reveal that their view of the immediate future is not nearly as fine and benign as you may think. Société Générale singles out private and public debt as the possible instigator for economic collapse, and tells clients that sovereign bonds will get them good returns. Goldman simply bets heavily against financials and against gold!.

Where the two diverge is in their view of the dollar: Société Générale sees it plunge further, whereas Goldman Sachs sees the opposite. And as much as it may chagrin us to agree with Goldman on anything at all, we do when it comes to the US dollar. We think of it as sort of the wounded crippled last one standing when the first smoke will begin to clear and the bodies are carried out. We don't doubt that oil and gold have very good odds for a strong comeback down the line, but they are not the obvious choice in a situation such as the one we see coming short term.

What we see is not gold vs. the USD or oil vs. the USD. We see risk versus the US dollar. Investors have not been risk averse the past months. And they still are not (yet). And stocks are up, and gold is up, and so is oil. And the dollar is down.

Risk versus the US dollar. If one goes down, the other goes up.

We think that right there you can see what will happen when investors and speculators and everybody else except for a few bravehearts will want to get away from risk, lose their appetite. At that point, it'll be either risk or the dollar. If you think investors will want to take on additional risk, in the face of the numbers on housing and jobs and CRE, a bet against the dollar makes sense. If you don't, that bet, in our view, makes no sense.

Ilargi: Ilargi: You don't have to be just an observer on a couch, and you shouldn't. This is not TV. You can be part of the Automatic Earth. By donating.

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New Jobless Claims Flat at 505,000

The number of U.S. workers filing new claims for jobless benefits last week remained unchanged from the prior week, the Labor Department said in its weekly report Thursday. Total claims lasting more than one week, meanwhile, declined. Initial claims for jobless benefits remained steady at 505,000 in the week ended Nov. 14. The previous week's level was revised to 505,000 from 502,000. Economists surveyed by Dow Jones Newswires had expected a slight increase of 4,000 claims. Despite the fact claims were unchanged in Thursday's report, economists have said they've seen some good trends in jobless claims figures recently.

"Jobless claims have been trending steadily downward, which is a positive sign for the labor market," economists at J.P. Morgan Chase & Co. wrote in an economic analysis last week. "Payroll employment losses have been quite steady for the last three months, but the drop in claims suggests that job losses could start to moderate again soon." The four-week moving average of new claims, which aims to smooth volatility in the data, fell by 6,500 to 514,000 from the previous week's revised average of 520,500. That is the lowest figure since November 22, 2008.

Initial claims still remain at a fairly high level and remained stagnant last week, suggesting the job market continues to face a sluggish recovery. Recent data showed that the unemployment rate in the U.S. hit 10.2% in October, which was up from 9.8% in September. In the Labor Department's Thursday report, the number of continuing claims -- those drawn by workers for more than one week in the week ended Nov. 7 -- fell by 39,000 to 5,611,000 from the preceding week's revised level of 5,650,000. The unemployment rate for workers with unemployment insurance for the week ended Nov. 7 was 4.3%, unchanged from the prior week's unrevised rate. The largest increase in initial claims for the week ending Nov. 7 was in Michigan due to layoffs in the automobile, construction and service sectors. The largest decrease in initial claims occurred in Florida.

One Million Americans Face Loss Of Jobless Benefits In January

The National Employment Law Project says that the public’s perception of what will happen to insurance benefits for the unemployed early next year is flawed. Most press reports on Congressional action on the matter say that one million people have had their benefits extended well into 2010. That apparently is not so. The NELP released a new analysis which finds that one million workers will become ineligible for unemployment benefits in January 2010 unless Congress reauthorizes the American Recovery and Reinvestment Act’s unemployment insurance programs by the end of December.

The organization writes “The critical benefits provided to jobless workers by the ARRA are set to expire at the end of the year, which means that even with the latest 14 to 20 week extension enacted in November, 30,000 workers a day will be left without any jobless benefits in January. By March, the number without federal jobless benefits will swell to nearly three million workers.” It has been widely assumed that the benefits for many of the unemployed had already been extended by as much as several months. The New York Times points out the problem with that reasoning: “The added federal benefits were built on a series of previous extensions that are slated to end on Dec. 31, unless Congress renews these programs.”

The NELP analysis is devastating because it means that the “social safety net” for millions of people could disappear in the early part of 2010. That will almost certainly lead to a number of troubling consequences which will include a rise in mortgage delinquencies, adults who cannot regularly put food on the table, and an increase in ranks of the homeless who will need to rely on shelters or friend and relatives for a place to live and sleep. It also means that the tiny amount of money these people might have spent, a very modest addition to nationwide consumer activity, will go away.

The Obama Administration plans to have a jobs summit on December 3rd. The purpose of this is to draw together political and private sector leaders to discuss means for stopping the rise in joblessness which has taken national unemployment to 10.2% and which will likely stay above 10% for most if not all of next year. The trouble is that the jobs summit comes a bit late. Any program that goes into effect will not clear Congress until early next year and the effects will almost certainly not be felt until the end of the first quarter. By that point, the economy could be in another rut caused in large part by a drop in consumer spending based on unemployment and the fear of many workers that they will join the jobless ranks soon.

There does not appear to be any solution to improving the employment situation without a second stimulus package, whether it is called that or not. Consumer spending, a rise in exports, and the $787 billion already being pumped into the economy have been inadequate. That does not leave many options beyond federal programs aimed very directly at putting people back to work.

Société Générale tells clients how to prepare for 'global collapse'

Société Générale has advised clients to be ready for a possible "global economic collapse" over the next two years, mapping a strategy of defensive investments to avoid wealth destruction. In a report entitled "Worst-case debt scenario", the bank's asset team said state rescue packages over the last year have merely transferred private liabilities onto sagging sovereign shoulders, creating a fresh set of problems.

Overall debt is still far too high in almost all rich economies as a share of GDP (350pc in the US), whether public or private. It must be reduced by the hard slog of "deleveraging", for years. "As yet, nobody can say with any certainty whether we have in fact escaped the prospect of a global economic collapse," said the 68-page report, headed by asset chief Daniel Fermon. It is an exploration of the dangers, not a forecast. Under the French bank's "Bear Case" scenario, the dollar would slide further and global equities would retest the March lows. Property prices would tumble again. Oil would fall back to $50 in 2010.

Governments have already shot their fiscal bolts. Even without fresh spending, public debt would explode within two years to 105pc of GDP in the UK, 125pc in the US and the eurozone, and 270pc in Japan. Worldwide state debt would reach $45 trillion, up two-and-a-half times in a decade. (UK figures look low because debt started from a low base. Mr Ferman said the UK would converge with Europe at 130pc of GDP by 2015 under the bear case).

The underlying debt burden is greater than it was after the Second World War, when nominal levels looked similar. Ageing populations will make it harder to erode debt through growth. "High public debt looks entirely unsustainable in the long run. We have almost reached a point of no return for government debt," it said. Inflating debt away might be seen by some governments as a lesser of evils. If so, gold would go "up, and up, and up" as the only safe haven from fiat paper money. Private debt is also crippling. Even if the US savings rate stabilises at 7pc, and all of it is used to pay down debt, it will still take nine years for households to reduce debt/income ratios to the safe levels of the 1980s.

The bank said the current crisis displays "compelling similarities" with Japan during its Lost Decade (or two), with a big difference: Japan was able to stay afloat by exporting into a robust global economy and by letting the yen fall. It is not possible for half the world to pursue this strategy at the same time. SocGen advises bears to sell the dollar and to "short" cyclical equities such as technology, auto, and travel to avoid being caught in the "inherent deflationary spiral". Emerging markets would not be spared. Paradoxically, they are more leveraged to the US growth than Wall Street itself. Farm commodities would hold up well, led by sugar.

Mr Fermon said junk bonds would lose 31pc of their value in 2010 alone. However, sovereign bonds would "generate turbo-charged returns" mimicking the secular slide in yields seen in Japan as the slump ground on. At one point Japan's 10-year yield dropped to 0.40pc. The Fed would hold down yields by purchasing more bonds. The European Central Bank would do less, for political reasons.

SocGen's case for buying sovereign bonds is controversial. A number of funds doubt whether the Japan scenario will be repeated, not least because Tokyo itself may be on the cusp of a debt compound crisis. Mr Fermon said his report had electrified clients on both sides of the Atlantic. "Everybody wants to know what the impact will be. A lot of hedge funds and bankers are worried," he said.

Goldman Sachs Betting on Derivatives Collapse Sparked Financial Crash?

Earlier this month, I detailed 25 US commercial banks that had trillions (with a “T”) of dollars’ worth of exposure to derivatives on their balance sheets. At the time, I stated that even if 4% of the notional value of these derivatives was “at risk” and only 10% of that 4% went bad, that you would wipe out the total equity at the five large US banks. Given how mortgage backed securities turned out (and those securities WERE regulated, unlike derivatives), I believe that most, if not ALL major banks in this country are insolvent or would be recognized as such if you marked the assets on their balance sheets at anything resembling market values. As a review, here’s the chart I presented revealing the banks and their derivative exposure:

Paints quite a picture, doesn’t it?

This alone explains in no uncertain terms that the Financial Crisis is anything but over. Sure the Federal Reserve may have pumped $800+ billion into the financial system, yes the Fed is buying some $1.2 trillion in mortgage-backed securities, and of course there are the Fed’s off balance sheet arrangements, which we cannot even begin to quantify. But ALL OF THESE efforts amount to diddily-squat in the face of TRILLIONS and TRILLIONS in potential losses in the derivatives market.

Sure, the banks may not publicly state how much of their derivatives are “at risk” but when you’re talking about $200+ TRILLION (an amount equal to four times GLOBAL GDP) it doesn’t really matter how much is “at risk.” As I said before, if even 4% of this is “at risk” and 10% of that 4% goes bad, you’re talking $800 billion in equity wiped out (that’s the entire equity of the five largest commercial banks). I know this… as does anyone who does a little homework on the banking industry. Including… THE BANKS THEMSELVES.

Goldman Sachs recently published its 13F, a quarterly filing in which all asset managers reveal their largest holdings. In it, Goldman’s asset management group reveals their largest long positions and their largest short positions. Now, Goldie is widely held to be the “smartest” guys on Wall Street (not my opinion) so their net shorts (the stocks or companies they’re betting AGAINST) were particularly interesting to me:

The above positions combine Goldman’s long and shorts (stock and option based positions) for the NET short positions. In simple terms, Goldman MAY be long these companies, but because the bank is ALSO shorting them (and shorting more shares than it is going long) it has NET short positions. Put another way, these are the companies or positions that Goldman is betting the most money on falling in the future.
For starters, FOUR of the top 10 are financial companies. The largest financial short is Wells Fargo, which Goldman has committed $289 million to betting against. After that it’s Mastercard ($266 million), then PNC ($202 million), and finally AIG ($152 million). Looking at Goldman’s positions, it’s plain as day that Wall Street’s “finest” do NOT believe the financial crisis is over (why are they betting against the banks if they do?). It’s also clear that Goldman’s analysts have noted as I have that both Wells Fargo and PNC both have massive exposure to the derivatives market (the fact that Goldman ALSO has massive derivative exposure is beyond ironic).

However, where things get absolutely absurd is Goldman’s short position of AIG. Goldman, as has been widely documented, was one of the largest benefactors of AIG’s bailout (the then investment bank had MASSIVE counter party exposure to AIG’s toxic balance sheet). To see Goldman now betting AGAINST AIG after receiving $13 billion in tax payer money to insure the former didn’t go under along with the latter is outrageous (if not infuriating) to say the least.

On a final note, I wanted to point out Goldman is also shorting a Euro index (betting against that currency) as well as two gold mining companies (Barrick and Agnico Eagle Mines). This indicates that Goldie is bearish on both the euro and gold which hints that Wall Street’s finest are likely betting on a US Dollar rally (that would, after all, be the most obvious catalyst for a correction in gold and the euro). To be blunt, it’s clear that Goldman (like me) believes the financial crisis is nowhere near over: four of its top ten largest shorts are financial companies. It’s also worth noting that Goldman is betting against gold and the euro. Given Goldman’s incredible access to and close relationship with the regulators and federal government, I see this as further proof that we may be seeing another stock crisis triggered by a Dollar rally in the near future.

Fire Geithner and Summers, prominent Democrat says

'We may have to sacrifice just two more jobs to get millions back for Americans'

President Barack Obama "is being failed by his economic team" and should replace Treasury Secretary Tim Geithner and White House economic policy director Larry Summers, says US House Rep. Peter DeFazio. The prominent member of the Congressional Progressive Caucus told MSNBC's The Ed Show that he and other House members are growing increasingly frustrated by a White House economic policy that focuses on maintaining the financial stability of Wall Street firms while largely overlooking Main Street concerns.

"I think there is a growing consensus in the [Democratic] caucus [that] we need a new economic team that cares more about jobs, Main Street and the American people than it does about Wall Street and huge bonuses," DeFazio (D-OR) told host Ed Schultz. DeFazio suggested that the government "reclaim the unspent funds ... reclaim some of the funds that are being paid back, which will not be paid back in full, and we use it to put people back to work rebuilding America's infrastructure. "We may have to sacrifice just two more jobs to get millions back for Americans," DeFazio said.

DeFazio criticized Geithner for not being forthcoming about where TARP bailout money went, saying that the treasury secretary was "absolutely not" coming clean about how the government used $700 billion of taxpayers' money to rescue ailing Wall Street firms. A news analysis at CBS published yesterday says that the US Treasury "gave away the farm" when it bailed out insurance giant AIG, pointing out that, in normal bankruptcy cases, creditors would receive only a fraction of the money they lent the bankrupt company.

But because AIG did not declare bankruptcy and was bailed out by TARP instead, taxpayers ended up being on the hook for 100 percent of the insurer's debts. Investment banking giant Goldman Sachs was AIG's largest creditor, and many observers argue it was Goldman's involvement in the bailout that resulted in AIG creditors receiving all the money owed them. DeFazio has a long track record of liberal populism. During the Bush administration era, he voted against Republican-sponsored tax cuts and funding measures for the Iraq war.

Geithner Rejects Call to Resign, Faults Republicans

Treasury Secretary Timothy Geithner defended the Obama administration’s economic record and dismissed a call for his resignation from the senior House Republican on the Joint Economic Committee.

Geithner blamed the policies of the Republican party and President George W. Bush for the financial crisis that pushed the nation into the deepest recession since the 1930s. Republicans “gave this president an economy falling off the cliff,” Geithner told Representative Kevin Brady of Texas as the two men interrupted each other during a hearing today. “I can’t take responsibility for the legacy of crises you bequeathed the country.”

Gearing up for next year’s elections, Republicans are training their sights on Geithner, an architect of the Wall Street bailout as Treasury secretary and in his previous job as president of the Federal Reserve Bank of New York. A report issued earlier this week critical of Geithner’s handling of the rescue of insurer American International Group Inc. has also prompted calls for him to quit. Today, the Treasury chief fired back, saying that by “any measure” of consumer or investor confidence, the economy is “substantially stronger today than when the president took office” in January.

The “worst financial crisis in generations” happened after “almost a decade, certainly eight years, of basic neglect of basic public goods, in health care, in education, in public infrastructure, in how we use energy,” Geithner said. Brady told Geithner that a growing number of liberal Democrats as well as conservative Republicans think that he is handling the economy poorly. “For the sake of our jobs, will you step down from your post?” Brady asked. “The public has lost all confidence in your ability to the do the job, and it is reflecting on your president.”

Another Republican on the panel, Representative Michael Burgess of Texas, told Geithner that he disagreed with Brady. “I don’t think you should be fired,” Burgess told Geithner. “I thought you should have never been hired.” Democrats on the panel defended Geithner. “It just amazes me how there are some people here who are trying to pretend, and I think consciously and intentionally pretending, that the economic circumstances that we’re confronting, all of them, mysteriously materialized over the course of the last nine months or so, which is totally, completely false,” said Representative Maurice Hinchey, a New York Democrat.

Earlier this week, former Republican congressman Rob Simmons, seeking a U.S. Senate seat from Connecticut, called on Geithner to resign over his role in the AIG bailout. Simmons, who is bidding to challenge Democratic incumbent Christopher Dodd in the 2010 election, cited the report issued Nov. 16 by the watchdog of the $700 billion Troubled Asset Relief Program that faulted the New York Fed -- with Geithner at its helm -- for making “limited efforts” to protect taxpayer funds during last year’s rescue of AIG. Dodd chairs the Senate Banking Committee, which is considering legislation to toughen oversight of the U.S. financial system.

In today’s hearing, Geithner also told lawmakers that the Treasury wants to end the TARP as soon as possible. “We are working to put TARP out of its misery,” he said. The Obama administration is moving “aggressively” to shut down “the programs that defined TARP at the beginning of the crisis,” he said. The department has already completed its guarantee for money-market mutual funds and it has ceased making capital injections into large banks.

US October Housing Starts Down 10.6% To 529,000

October housing starts unexpectedly plunged by 10.6% to an annualized rate of 529,000 units, well below the 600,000 unit pace economists were expecting. October's decline followed a 1.9% rise in September to an upwardly revised 592,000 annual units (was 590k). The October decline was due largely to a 33.3% drop in multi-family homes (5 or more units) to a new record low 48,000 annual units. Single family housing starts, seen as a more reliable indicator of the housing sector, fell 6.8% in October to 476,000 units. Single family starts fell in all regions of the country: by 9.6% in the Northeast, by 4.8% in the Midwest, 7.3% in the South and 5.9% in the West.

October building permits fell by 4.0% to 552,000 annual units from an upwardly revised 575,000 units in September (was 573k). Economists were expecting the number of permits in the month to rise to an annualized rate of 580,000 units. Like housing starts, the decline in building permits was due largely to a huge drop in multi-family permits. Permits for buildings with five or more units fell 18.3% to 85,000 units. Single family permits fell 0.2% to 451,000 units. Single family permits fell in only two of the four regions: by 1.4% in the Midwest and by 1.3% in the South. In the Northeast, single family permits rose 2.2% while single family authorizations rose 2.1% in the West.

A record low 560,000 units are still under construction, down 3.4% from September. Single family homes under construction are down 1.6% to a record low 310,000 units while construction of multi-family homes fell 6.0% to 236,000 units, its lowest level since March 1997. The number of homes completed in the month rose 1.9% to 740,000.

Housing starts and building permits
by Dave Rosenberg

Housing starts were supposed to edge up to 600,000 units (annualized) in October, but instead they cratered 10.6% MoM to 529,000 units in the worst decline since the depths of despair last January; the level is at the lowest since April when the ‘shoots’ were still green (instead of brown).

Both single-family (-6.8% MoM) and multi-family (-34.6% MoM) starts were lower, but no doubt we will hear from economists that this plunge was before the announcement of the extension and expansion of the government tax credits for first-time and now trade-up buyers. But it is nice to know what the economy in general and housing in particular look like when the fiscal taps aren’t running at full tilt — it’s not a pretty picture. The tax credits for homeownership are not a win-win because they lure people out of rental units — so we now have a situation where multiple unit construction in October fell to a RECORD low of just 53,000 units at an annual rate (unreal).

The fact that permits also dropped 4% MoM (second decline in a row) and the soft 17 print on the NAHB housing market index for November suggest that the housing rebound was nothing more than a six-month deal. Even the home-buying intentions components of the consumer confidence surveys are signaling this. As an aside, if sales do not pickup, then we will likely see the inventory backdrop worsen again and prices deteriorate because what stood out in the data was the 10.7% surge in single-family completions — the largest increase in over a year and the highest level since April.

Mortgage applications came out for the November 13th week and were shockingly weak in view of the just-announced expansion of the government stimulus, which was announced at the end of October! Applications were down 2.5% but the really disturbing news was the 4.7% slide in the applications for new purchases, which is on top of the 11.7% plunge the week before — down 15% from last year’s depressed levels and the lowest since November 1997!

The FHA's nose dive

Another housing agency takes taxpayers for a dangerous ride.

The cost of the housing bailout continues to rise. The government-run mortgage giant Fannie Mae requested another $15 billion from the Treasury this month, to help cover a loss of $19.8 billion in the third quarter. That brings the total tab for rescuing Fannie to $60 billion so far. Fannie's twin, Freddie Mac, has received $51 billion. And now comes news that the capital reserves of the Federal Housing Administration (FHA) have fallen to $3.6 billion, which is just one-half of 1 percent of the $685 billion in loans insured by the agency and well below the statutory minimum of 2 percent.

Does this mean that Congress will soon be shoveling more billions into the FHA? Possibly. But it's important to understand the precise nature of the FHA's predicament. Whereas Fannie and Freddie are in the business of securitizing mortgages, the FHA insures them directly. Borrowers of modest means can get houses with as little as 3.5 percent down; if they default, the FHA pays off the lender from accumulated insurance premiums.

During the bubble, subprime firms "served" anyone with a remotely plausible ability to borrow, and the FHA's market share waned. The FHA tried to compete by accepting down payments supplied by sellers to borrowers via nonprofit organizations. These were, in effect, loans of very poor quality that required no down payment, and they have been defaulting in bunches. The FHA says that, without these clunkers in its portfolio, the agency could meet the statutory capital requirements today.

In the past year, as private investors have left the mortgage field, Congress and the White House (under President George W. Bush and President Obama alike) have encouraged the FHA to fill the void. The agency insured $360 billion worth of single-family loans in fiscal 2009 -- five times as much as it insured in fiscal 2005. Today, about half of first-time homebuyers turn to the FHA. Though quite a few of these new loans are of questionable quality, too, the FHA says that the average quality of its booming portfolio has increased, if only because good borrowers have so few alternatives.

Low as its reserves are, the agency estimates that the insurance premiums from a growing, new book of business will enable it to cover, just barely, losses from the rapidly decaying old book, after which it can rebuild reserves. You could compare the FHA to the pilot of an acrobatic biplane: in a nosedive but capable of pulling out of it in the nick of time. If the housing market performs worse than the FHA's current worst-case scenarios, however, the agency will crash and burn.

The problem here is that the government is taking taxpayers on such a death-defying ride in the first place.

Like Fannie Mae and Freddie Mac, the FHA represented a huge federal gamble on the politically popular cause of homeownership.

Now that Washington has lost that bet, it is doubling down, in a bid to prop up home prices just enough to prevent a wider collapse of the economy.

Perhaps this stopgap will work, perhaps not. Certainly it's odd that the FHA is helping people get houses with very little equity even as rental vacancies are running at an all-time high of 11.1 percent. But the broader lesson is that federal subsidies have made the entire economy dangerously dependent on single-family housing. The sooner Congress and the president go to work on a long-term fix for that fundamental problem, the better.

FHA-Backed Lending Is a 'Train Wreck,' Toll Says

The Federal Housing Administration, the agency that insures home purchases made with down payments as small as 3.5 percent, may create another lending crisis, Toll Brothers Inc. Chief Executive Officer Robert Toll said. “Yesterday’s subprime is today’s FHA,” Toll said today at a New York conference for builders sponsored by UBS AG. “It’s a definite train wreck and the flag will go up in the next couple of months: Bail us out. Give us more money.” Toll Brothers is largest U.S. luxury homes builder.

The FHA’s insurance reserve ratio fell to 0.53 percent, the lowest level in history, and more steps are needed to shore up the agency that guarantees one of every five single family loans, Housing and Urban Development Secretary Shaun Donovan said Nov. 12. While the insurance fund’s capital ratio is at an all-time low, Donovan said those who say FHA is the next subprime- mortgage crisis are “dead wrong.” The quality of the loans FHA insures is “actually very good,” Donovan said.

FHA’s total reserves are more than $31 billion, giving it an overall capital resource ratio of 4.5 percent, according to statement by FHA Commissioner David Stevens. The 0.53 percent net capital loan insurance ratio takes into account projected losses and is the yardstick Congress uses to determine the health of the fund. Congress requires the FHA to maintain a loan reserve ratio of at least 2 percent to protect the insurance fund from default.

The FHA said 456,000 of its loans, or 8.2 percent, were in default as of September. That was up from 5.6 percent in September 2008. The default rate for loans tracked by the Mortgage Bankers Association was a record 9.24 percent for the three months through June, the most recent period for which data is available. That was up from 6.41 percent a year earlier. FHA loans accounted for about 8 percent of the mortgages Toll Brothers closed in the past quarter, Robert Toll said. About 80 percent of the company’s financing is loans guaranteed by Fannie Mae or Freddie Mac, he said. Those government- supported agencies require larger down payments and better credit than loans insured by the FHA.

Toll Brothers has seen strong sales at its urban high-rise developments in New York City, Jersey City and Philadelphia, Toll said. “We started doing over $1 million product even in Hoboken and Jersey City,” he said. “We expect to expand to Washington, D.C., and perhaps some other strong markets.” Horsham, Pennsylvania-based Toll Brothers fel1 12 cents to $20.71 at 3:16 p.m. in New York Stock Exchange composite trading. The shares are down 2.8 percent this year through yesterday.

Investors strategize for Fed's exit from MBS market

Investors who reaped robust gains in U.S. mortgage-backed securities by piggy-backing on the Federal Reserve's $1.25 trillion buying program are bracing for the end to the central bank's support -- and positioning themselves for a new round of profits as prices cheapen. The $5 trillion market for bonds backed by the housing finance companies Fannie Mae, Freddie Mac and Ginnie Mae is in for a shock when the Fed stops buying at the end of the 2010 first quarter.

To keep market volatility from stripping away gains, investors have either cut their holdings in the bonds the Fed has been buying most, avoided that part of the market altogether, or resorted to hedging their positions. Fed buying, just over $1 trillion so far, has not only played a key role in bringing down mortgage rates and kick-starting the hard-hit housing market, but also boosted returns at some of the world's largest bond funds.

As the program winds down investors are preparing for greater volatility. Many are forecasting the sector could cheapen anywhere from 20 to 35 basis points versus Treasuries, which would pare some of sector's significant gains. Indeed, agency MBS have tightened by about 73 basis points against Treasuries this year. A much sharper cheapening of prices, however, may be warranted to boost enough buying to fill the Fed's big shoes.

"Based on current market conditions, I believe that U.S. agency MBS current coupon spreads would need to widen anywhere from 50 to 70 basis points relative to U.S. Treasuries in order to fill the demand currently provided by the Fed," said Joe Ramos, lead portfolio manager on the U.S. fixed income team at Lazard Asset Management in New York. The Fed's purchases of one-sixth of all MBS backed by Fannie Mae, Freddie Mac and Ginnie Mae has recently been focused on coupons yielding 4.50 percent through 5.50 percent.

Martin Sass, chairman and chief executive officer of New York-based MD SASS, said his firm has circumvented those securities, calling them "the most vulnerable." "We are buying the more seasoned, older mortgage-backed pools. They tend to be less efficiently priced and they are not the ones the Fed is buying," he said. In addition, Sass, whose firm holds roughly $2 billion in MBS and has been in the market since 1977, said he and others are keeping "dry powder" for an expected fall in prices, although he does not expect an overly dramatic drop.

He expects yields to remain supported by Fed buying of MBS through the end of the program after which spreads could potentially widen 30-35 basis points. Deutsche Bank's Bill Chepolis, a senior portfolio manager at its retail asset management unit DWS Investments, said in the last quarter his firm sold agency MBS. If the Fed keeps interest rates stable Chepolis said he would hold more benchmark U.S. Treasuries in anticipation of a weaker agency MBS market.

"We can also sell call options in forward months to make a bet that prices will be lower then," he said. "Another strategy people employ, ourselves included, is to buy interest-only MBS. These have negative durations, so go up in price as rates and MBS rates rise." Negative duration bonds, as opposed to a typical bond, go up in price when rates go up and down in price when rates go down.

Another popular move has been the so-called "up-in-coupon" trade which entails selling lower yielding coupons in exchange for higher yielding issues. This has occurred largely because U.S. interest rates have dropped sharply as investors have sought a safe haven during the economic crisis. At the end of the third quarter, Pacific Investment Management Co, the world's biggest fixed income fund manager, known as Pimco, highlighted its reduced exposure to mortgages over the course of this year in anticipation of the Fed's program running its course. "Pimco plans to maintain a flat to underweight position in mortgages as Fed purchases have driven agency MBS to their near richest levels ever. We look to reenter the market when valuations are more compelling," the firm said.

According to results of JPMorgan's October investor survey covering over 160 investors and over $2 trillion in mortgage assets, over half polled are now underweight mortgages, up from a mere 20 percent in July. "At current market levels we see no investors filling the void," said Lazard's Ramos. Ramos said until the decline in financial institutions subsides, the biggest holder of agency MBS away from the Fed will be retirement fixed income allocations that are benchmarked against U.S. aggregate indexes such as Barclays Aggregate Index.

Barclays reported on Nov. 12 that according to Federal Reserve data, the top 50 banks shed $34 billion worth residential MBS in the third quarter. "Interestingly, this decline was driven primarily by a select group of banks including Wells Fargo and Bank of America. Excluding these banks, the remaining top 48 banks increased their MBS holdings by $9 billion," Barclays said. At the end of September the top 50 banks held $964 billion in MBS, Barclays said.

"This is not like the market goes away when the Fed stops buying," said Jay Diamond, managing director of Annaly Capital Management in New York. "There might be some repricing but people chase yield and they'll find this at some point," he said.

Fear of Double Dip in Housing

The U.S. housing market is sputtering again, adding to doubts about the vigor of the economic recovery. Just a few months after housing showed signs of leveling off, bad weather and uncertainty over the extension of a home-buyer tax credit sent new-home starts in October tumbling 10.6% from the previous month. They fell to the lowest level since April, the Commerce Department said Wednesday. Starts of single-family houses fell 6.8%. Earlier this month, Congress expanded the tax credit and extended it through April, so building should improve. Still, the latest data portend poorly for the economy overall, and for fourth-quarter growth.

On Wednesday Pulte Homes Inc., the nation's largest home builder, warned investors of a grim outlook. "As we look out to 2010, we are expecting difficult conditions to continue," said chief executive Richard Dugas. Meanwhile, more Americans who bought homes during the boom are falling into mortgage limbo. About 3.4% of U.S. households -- or about 1.9 million homeowners -- are 120 days or more overdue on their payments, but not yet in foreclosure, according to LPS Applied Analytics, a research firm in Denver. That is up from 1.5% a year earlier. Many of these people are likely to lose their homes over the next few years. That means more bank-owned homes will hit a market already suffering from oversupply.

The housing-supply picture is tricky to read. The number of homes listed for sale was 3.63 million in September, down 15% from a year earlier, according to the National Association of Realtors. That is enough to last about eight months at the current rate of sales. Anything above about six months is considered a buyer's market, in which prices may come under downward pressure. But those numbers don't reflect the millions of homes expected to go through foreclosure over the next few years, adding to supply. Amherst Securities Group in September estimated seven million homes are headed for foreclosure in the next few years -- more than a year's home sales at the current rate.

"Housing faces important problems, including continuing high foreclosure rates," Federal Reserve Chairman Ben Bernanke said in a speech Monday. "But residential investment should become a small positive for growth next year rather than a significant drag, as has been the case for the past several years." For borrowers with strong credit records, 30-year home mortgages are available for fixed rates of just under 5%, near the lowest levels in 50 years. That is helping demand, but many people can't get such loans because they have too much debt or are unemployed.

One measure of the role of housing in the economy earlier this decade: During the boom, residential investment peaked to make up 6.3% of gross domestic product. That number fell to 2.5% in the third quarter, according to Macroeconomic Advisers. The average U.S. home price nearly doubled between January 2000 and April 2006, according to the First American LoanPerformance index. Since then, the average has dropped about 30%. In most parts of the U.S., prices are still down from year-ago levels, but prices in some markets, including San Diego and Orange County, Calif., have leveled off, at least temporarily.

Wednesday's data prompted some economists to revise their fourth-quarter forecasts down slightly. Macroeconomic Advisers moved its GDP estimate down to 3% from 3.2% and Nomura Securities is predicting 3.4% growth, down from 3.6%. The data adds to the suggestion "that the recovery is a little bit rickety," said Zach Pandl, a Nomura economist. Eventually, the steep drop in construction of new homes should help reduce the number of unsold vacant homes to the point where builders need to step up production. But the latest data highlight the fragility of the housing market, which has been propped up by the tax credit and the Fed's efforts to push down mortgage rates.

With the tax credit set to expire in April and the Fed scheduled to wind down its purchases of mortgage-backed securities by the end of March, housing faces a test of its ability to sustain a recovery without as much government aid.
Potential homebuyers are frustrated by the complications of a market dominated by distressed sellers. Tim Kolstad, a financial consultant renting in Scottsdale, Ariz., has been trying to buy a home for more than a year. But the homes he likes are all either foreclosed or being offered for less than the loan balance due -- which means any offer from a potential buyer must be cleared by the lender, and lenders often are slow to respond. "The offers just sit out there forever," Mr. Kolstad said.

Credit standards are "definitely tighter than they were" in previous years, said Bryan Mitchell, an agent Re/Max Associates in Las Vegas. At least two years of job history, low debt and a good credit score are essential to securing a loan. "You have to have all three, you can't be missing one," he said. But some economists see signs of better demand ahead. "I think that there's been a lot of doubling up in this recession," said Patrick Newport, an IHS Global Insight economist. "People lose their jobs so they move in with relatives. Your kid graduates from college, he can't get a job, so he stays at home. That's going to start going the other way."

Single family home-building is still 10.9% below year-ago levels. New homebuilding fell to a seasonally adjusted annual rate of 529,000 units, the lowest since April. And apartment-complex construction fell as high vacancy rates, declining rents and borrowing difficulties have deterred builders. Building permits, a sign of future construction, also decreased 4%.

The number of people awaiting foreclosure action has ballooned partly because the government has prodded lenders to consider reducing payments for many distressed borrowers in an effort to avert foreclosures. At the same time, loan-servicing companies, the firms that collect mortgage payments and handle foreclosures, are overwhelmed by the millions of distressed borrowers. "There is only so much volume that can be processed by the servicers each month," said Herb Blecher, a vice president at LPS. Overall, about 12.4% of American households with mortgages in October were 30 days or more overdue or in the foreclosure process, according to LPS. That's up from 12.3% in September and 8.6% in October 2008. In the latest month, about 6.9 million households fell into this category.

Obama warns on US public debt pile

US President Barack Obama warned that the US economy could head into a “double-dip recession” unless urgent steps were taken to rein in mounting public debt. The US president’s remarks – in an interview with Fox News in Beijing on Wednesday, towards the end of his eight-day tour of Asia – marked his strongest language yet on the necessity of putting public finances back on a sound footing.

“It is important though to recognise if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the US economy in a double-dip recession,” said Mr Obama. A 10.6 per cent plunge in housing starts in October – led by collapse in the apartment business – highlighted the dilemma facing him as he seeks to tackle the deficit without undermining a fragile economy. “It’s about as hard of a play as there is,” Mr Obama said, adding that his team was trying to set up a “pathway long term for deficit reduction” without pulling a lot of money out of the economy in the short term via tax rises or spending cuts.

The mood in the US has already swung in favour of deficit reduction, with Republicans attacking Democrats’ plans for more spending to support jobs. Washington-based analysts said the president was probably trying to prepare public opinion for a tough budget in February – while leaving open some space for measures to reduce unemployment, now at 10.2 per cent. “I have no doubt that the White House is going to produce a tough budget,” said Maya MacGuineas, director of the Peterson-Pew commission on budget reform. “The question is whether they are going to spend political capital and push their budget in Congress.”

The timing of Mr Obama’s remarks, which came at the end of his three-day trip to China, is likely to fuel speculation that his Chinese hosts delivered stern private warnings about the consequences of continuing high US budget deficits. China, the biggest foreign holder of US Treasury bonds, has become increasingly vocal in its fears on the value of its dollar assets. White House officials say the US fiscal situation had no impact on Obama’s interactions in Beijing, even though some observers presented his trip as that of a debtor visiting his banker. “He pulled no punches,” said Mike Froman, a senior national security adviser. A day earlier, White House budget chief Peter Orszag said the US had to bring down its deficit to about 3 per cent of gross domestic product within six years – a reduction of about one percentage point of GDP based on the administration’s current estimates.

Fannie, Freddie Woes Hurt Apartments

The deteriorating commercial real-estate market is hitting Fannie Mae and Freddie Mac, the housing-finance giants that were taken over by the U.S. last year after billions of dollars in losses on residential real estate. The firms, which together have taken more than $110 billion in capital infusions from the Treasury, stepped up their lending for apartment buildings as the commercial real-estate market peaked, and they are now facing rapidly rising loan losses.

Fannie, which has been more active than Freddie, faces the biggest problems. Its serious delinquency rate, or loans that were 60 days or more past due, stood at 0.62% at the end of September, up from 0.16% a year ago. One troubling sign: one-quarter of the $180 billion of apartment-building loans on Fannie’s books were originated near the top of the market in 2007 and those loans account for nearly half of all its commercial-loan delinquencies. Fannie increased to $1.2 billion its reserves for losses on multifamily loans at the end of September, up from $104 million at the end of 2008. In a statement, Fannie Mae said market fundamentals “will remain under pressure in the near term” and that the company is taking steps “to mitigate risks associated with weak rental demand.”

The losses from Fannie’s and Freddie’s $300 billion in apartment-building loans will be a fraction of their losses on single-family homes, where the two firms back $5 trillion of loans. But the bigger impact could be on the market for apartment buildings. The firms were responsible for 84% of all multifamily lending last year, up from 34% of the market in 2006, according to the Federal Housing Finance Agency.

A report published earlier this year by Harvard University’s Joint Center for Housing Studies warned that without Fannie’s and Freddie’s continued purchases, “apartment transactions could come to a near standstill” and that could spur a further unraveling where even “cash-flow-positive projects may not be able to get refinanced and will be pushed towards default.” Fannie and Freddie say they were conservative in underwriting of apartment-building loans. For example, 97% of Freddie’s loans are still worth more than the value of the underlying properties. “We were careful about our credit, but with the markets deteriorating, everybody will be impacted negatively in some form or another,” said Freddie spokeswoman Patti Boerger.

But, in recent years, critics say that the firms became more aggressive. Some deals that they financed wouldn’t have occurred without their participation. “By 2007, Fannie basically put more gas on the fire,” says Mike Kelly, president of Caldera Asset Management, a consulting firm fordistressed multifamily properties. For example, Fannie and Freddie together lent $9 billion to finance the buyout of apartment operator Archstone-Smith by Lehman Brothers Holdings Inc. and Tishman Speyer Properties. The original plan—to carve up the portfolio and flip assets—didn’t pan out as real-estate values softened. “There was no policy justification to provide billions of dollars of financing for a deal that in retrospect tested the limits of aggressiveness in financing,” says Sam Chandan, president of Real Estate Econometrics, a research firm.

Fannie and Freddie also bought $1.5 billion in commercial mortgage-backed securities backed by the sprawling Peter Cooper Village-Stuyvesant Town apartment complex in Manhattan, for which a Tishman-led partnership paid a record $5.4 billion in 2006. The new owners weren’t able to convert as many rent-regulated units to market rates, and the loan has been transferred to a special servicer. The property could be worth as little as $1.8 billion now, according to an estimate by Fitch Ratings, which last month said that the tranche of securities held by Fannie and Freddie faces a “medium-to-low” risk of severe loss.

Most of Fannie’s and Freddie’s multifamily loans won’t mature for several years—two thirds of Fannie’s multifamily debt won’t mature until after 2013, for instance—allowing time for rents and vacancies to recover before owners have to refinance. Still, delinquencies stood at 1.6% on some $4.5 billion in loans set to mature next year. And those looming maturities only add to the uncertainty about whether Fannie or Freddie will stay active in the multifamily space over the medium to long term.

So far, various proposals that address how to revamp Fannie and Freddie haven’t paid much attention to multifamily lending, but industry leaders say they aren’t concerned. While it would be a “very big blow” to the sector if Fannie or Freddie were forced to sharply curtail their multifamily lending, “that’s just not in the cards,” says Richard Campo, chief executive of Camden Properties Trust, an apartment company with some 62,000 units. “The idea that the government is going to do something negative to affordable housing in this interim period … seems pretty far fetched.”

Fears of China property bubble

A large bubble is forming in China’s property market as a result of Beijing’s credit-driven stimulus programme, one of the country’s most prominent real estate developers warned. Zhang Xin, chief executive of Soho China, one of the country’s most successful privately owned property developers, told the Financial Times the asset bubble was leading to rampant wasteful investment in the sector, undermining the country’s long-term growth prospects.

“Real estate prices should only go up because people want to actually use the space, but at the moment we can see more and more empty buildings across the whole country and in every real estate segment,” Ms Zhang said. “The rising prices are a direct result of so much money coming from the banks and the Chinese banks should be very worried.” Ms Zhang’s assessment was echoed by Fan Gang, a member of the central bank’s monetary policy committee, who warned on Wednesday that real estate in cities such as Beijing, Shanghai and Shenzhen was expensive and there was a growing risk of asset price bubbles.

Urban property prices in 70 big and medium-sized Chinese cities rose 3.9 per cent in October from a year earlier, accelerating from September’s 2.8 per cent rise, according to government figures. Price rises in top-tier markets such as Beijing and Shanghai have been much faster. Analysts say the rebound has largely been driven by an unprecedented government-led expansion of bank lending. It is also being driven by government policies, including tax breaks, low interest rates and smaller down-payment requirements. Investment in real estate development, a key driver of economic growth, rose 18.9 per cent in the first 10 months of the year on a year earlier, a marked acceleration from 17.7 per cent growth in January-September.

Ms Zhang said the current speculation should be a serious warning for the industry and the general economy. “In Manhattan, they have vacancy rates of 10-15 per cent and they feel like the sky is falling, but in Pudong [the central business district in Shanghai] vacancy rates are as high as 50 per cent and they are still building new skyscrapers,” she said. “If you look at GDP growth, then China looks like a new engine driving the global economy, but if you look at how growth is being created here by so much wasteful investment you wouldn’t be so optimistic.”

Core deflation in the US continues to gather pace

Core inflation for factory goods in the US fell to minus 0.6pc in October from a year earlier, edging the country closer towards Japanese-style deflation despite massive monetary stimulus. Factory gate inflation typically leads consumer prices by six months or so. The “core” measure favoured by the Federal Reserve strips out energy costs. Janet Yellen, the head of the San Francisco Fed, said emergency measures had prevented the US economy from sliding into a “black hole of deflation”, insisting that it is still far too early to talk of tightening policy. A combination of “enormous slack in the economy” and fading fiscal support raised the risk that prices could fall below the Fed’s safe level. “It seems probable that core inflation will move even lower over the next few years,” she said.

Unemployment has reached 10.2pc and the average working week has fallen to a record low of 33.0 hours, creating powerful deflation headwinds. Gabriel Stein from Lombard Street Research said the US “output gap” is currently at 6.2pc of GDP. The last time it was near this level – in 1982 – producer price inflation fell by 300 basis points over the next year. A repeat today would cause it to spiral to dangerous levels below minus 3pc. While the Fed appears split over its exit strategy, even arch-hawk Richard Fisher of the Dallas Fed said the sheer scale of excess plant will curb prices and wages for a long time. Capacity use in manufacturing is near a post-war low of 67.6pc.

Mr Fisher said the “peak impact” of the Obama fiscal blitz has already come and gone. “Several recent sources of strength are likely to wane as we head into next year. Cash-for-clunkers and the first-time-homebuyer tax credit have both shifted demand forward, increasing sales today at the expense of sales tomorrow. Neither of these programmes can be repeated with any real hope of achieving anywhere near the same effect. The more demand you steal from the future, the less future demand there is for you to steal,” he said. “Chastised by recent experience, businesses will continue to run tight ships. It may be some time before significant job growth occurs and even longer before we see meaningful declines in the unemployment rate.”

Bank credit has been shrinking at an accelerating pace since May, though bonds and commercial paper have partly stepped into the breach. “I haven’t been this bearish in a year,” said bank guru Meredith Whitney on CNBC. The M3 money supply has been shrinking at a 7pc annualised rate since June. Paul Ashworth from Capital Economics said it is not yet clear whether this is the harbinger of a crunch next year, or a blip caused by portfolio shifts. “We think deflation is still a bigger risk than runaway inflation,” he said.

How Fed Manages to Keep Inflation Fears Under Control

Sometimes stating the obvious and repeating it frequently can be a very effective policy, especially in managing inflation expectations. And that’s what the majority of the Federal Reserve’s policy-setting team is doing in dealing with the inflationary potential of the extraordinary monetary and fiscal stimulus at work in the economy.

Key central bank players know that the “Fed’s current monetary policy is inconsistent with its long-term policy of keeping inflation low,” says Bank of America Chief Economist Mickey Levy. “I think it’s important for the Fed to say, 'We know what we're doing, that there are but extenuating circumstances and that we still have our eye on long-term objectives.'” Fed Chairman Ben Bernanke, Vice Chairman Donald Kohn and San Francisco Fed President, Janet Yellen, who also served as a board governor, have all said as much this week. “The Fed had made the point that expectations are important,” says Robert Brusca, chief economist at Fact & Opinion Economics. “They affect the way people act.”

And think. And despite a rush into gold, most would say that inflation expectations have been well managed and are under control. The few telltale signs out there confirm that. Spreads between Treasury Inflation Protected Securities, TIPS, and regular cash-based Treasury bonds and notes of varying duration have drifted between 1.50 percent and 2.0 percent in recent months, which happens to fall within the Fed’s supposedly target range for inflation. And for all the worry about the Obama administration’s borrowing boom, Treasury auctions have drawn sufficient interest to avoid building a premium into the yields.

“We're a good ways from that happening,” says David Resler, chief economist at Nomura Securities. The difference between seven months ago and now is notable. Back then, when the Obama administration’s big spending ways were new and all too apparent and there were lingering doubts about the effectiveness of the Fed’s program to buy various kinds of government debt in the markets, yields jumped, with the 10-year note breaking 4 percent in the middle of a brutal recession.

Also back then, market pundits and fiscal conservatives in Congress were doing most of the talking about inflation and driving expectations — higher. It was hard to argue with the logic. In the past, easy monetary policy, or government spending, or both raised inflationary expectations and as a result interest rates. It happened during the Reagan and the Nixon administrations in what might be considered more normal circumstances. It even seemed to be on the verge of happening in the Greenspan-Bernanke handover period at the Fed.

Don’t even think about it now, say most analysts. Not that there still isn’t a vocal minority, which happens to include Fed presidents Jeffrey Lacker, Charles Plosser and James Bullard. Lacker Tuesday warned that concerns about “lingering weakness” in some areas of the economy are not reason enough to risk an inflationary outbreak. That group and others may remember the rare times when the Fed got it wrong, such as in the late 70s.

Then, as now, the operative word for the economy is slack. Growth — along with demand — is so weak that price or wage inflation is considered almost impossible. Inventory is sufficient. Hiring unlikely or minimal. “The Fed's public statements about the slack have helped allay concerns,” says Levy. What’s more, banks may be sitting on billions of dollars in cheap money, but they are not lending it and consumers are hardly rushing to borrow it. Wages are largely stagnant. “You’re looking for the beast, but all you have is rhetoric,” says Brusca, describing what some are calling a paradox.

Economists say the Fed appears confident it can withdraw monetary stimulus—especially the unconventional measures — when it needs to, fostering growth and job creation, with inflation remaining subdued “for several years", according to Yellen in comments after her speech Tuesday. Bernanke Monday talked about “exceptionally low levels of the federal funds rate for an extended period.”

On the same day Kohn said the Fed needed to be “alert to any tendencies for movements in prices for commodities and assets to result in a sustained increase in inflation and inflation expectations.” You’d think rhetorical barrages like the past two days would be enough for the markets. And it may be. But in a way even the people calling the shots may need some reassuring and repeating themselves may help. “We’ve never been through this before,” says Patrick Newport, an economist at Global Insight. “We're not a 100-percent sure this is going to work.”

What Stinkin' Inflation? PPI Edition

Briefing detailed the latest PPI release:
The producer price index rose 0.3% in October, well below the consensus expectation of an increase of 0.5%.

Excluding food and energy prices, core PPI fell an astounding 0.6% over the month. For the year, core PPI has only increased 0.7% after posting a 1.4% year-over-year increase in September.

On the surface, the numbers would suggest an increasingly deflationary environment. However, the data for October was skewed.

The decline in core prices was due to large drops in vehicle prices. Passenger car prices declined 0.5% month-over-month after increasing 1.0%. Light truck prices fell 5.2% and heavy trucks prices declined 0.1%.

Briefing then poorly explains the drop in auto prices:
The information on the decline in motor vehicle prices is sketchy. New 2010 model year vehicle prices were introduced in this month's PPI report. The drop in price would suggest that car manufacturers are planning on introducing new model vehicles at lower price points. If this hold true, prices should hold at these levels through next summer.
But Market News quickly disproves this theory:
Core was cut by -5.2% in light trucks and -0.5% in cars where quality changes/model year changes and slack demand cut prices. The Bureau of Labor Statistics said the value of quality changes for 2010 model cars was $250 and for light trucks $793, less than usual, and that this pricing was adjusted out.
My thought of why there was an increase (and this could be wrong). Cash for clunkers. When the government was throwing cash at the end-user, this artificially increased demand for autos (by dealers) from producers. As the program ran out, the demand ran out, thus the pricing power ran out.

Too logical?

Ambac Faces 99% Chance of Default as Deadline Looms, Swaps Show

Ambac Financial Group Inc.’s bond- insurance unit faces a 99 percent chance of default, credit derivatives show, as financial institutions brace for the second-largest bond insurer to file a capital update with regulators later today. Five-year credit-default swaps on Ambac Assurance Corp. have jumped 3.2 percentage points since Nov. 9 to 78.3 percent upfront, according to CMA DataVision. That’s in addition to 5 percent a year, meaning it would cost $7.83 million initially and $500,000 annually to protect $10 million of Ambac obligations from default.

With market expectations that holders of Ambac-insured bonds would be able to recover 17.5 cents on the dollar, the price implies a 99 percent chance of default, CMA data show. Ambac faces a deadline today to update Wisconsin insurance regulators on its capital levels as of the end of the third quarter. Bond insurers regulated in Wisconsin are required to maintain minimum surpluses or risk being taken over. Regulatory intervention could accelerate demands against Ambac’s insurance unit.

“We believe that the most likely action by Wisconsin insurance regulators will be no action,” Rob Haines, an analyst with CreditSights Inc. wrote in a research report today. “Regulators are predisposed towards any work-out solution which could avoid the so-called ‘nuclear event.’” The company was stripped of its top bond insurance rating last year after surging loss projections on securities backed by soured home loans. Earlier this month, JPMorgan Chase & Co. analyst Andrew Wessel said Ambac’s regulatory capital is likely to have fallen into a deficit.

Delinquency proceedings against the company would trigger termination payouts of $23.1 billion by its insurance unit on credit-default swap contracts, Ambac said in a filing earlier this month. Ambac also may be required to accelerate the payment of $1.6 billion of holding-company debt, the New York-based bond insurer said in the filing. To prevent takeovers, insurers have paid holders to tear up credit-default swap contracts on their poorest-performing securities.

Credit-default swaps pay the buyer face value if a borrower defaults on its debts in exchange for the underlying securities or the cash equivalent. Banks that bought credit swaps from Ambac and other insurers to hedge against losses on mortgage- related securities used swaps on the insurers to protect themselves if the companies fail to make good on the guarantees. Peter Poillon, a spokesman for Ambac, didn’t immediately return a phone call seeking comment. Armonk, New York-based MBIA Inc. is the largest bond insurer.

Ambac Reports $856M Of Surplus, Easing Fears; Shares Rise

Ambac Financial Group Inc. (ABK) reported $856 million of surplus as of Sept. 30, more than double the second quarter's level, easing concerns the bond insurer would fall short of statutory minimums. Shares jumped 24 cents, or 34.3%, to 94 cents recently. The stock, however, is still down 17% this month. Some Wall Street analysts had speculated the insurer would come up short of $2 million in minimum capital needed under rules set up by its regulator, the Wisconsin insurance commissioner.

Meanwhile, Ambac said Wednesday it had negotiated to settle four derivatives contracts worth $5.03 billion for cash payments of about $520 million. Ambac said earlier this month that it had been working to negotiate a settlement. The capital figure, which came in filing made two days late, also included the impact from one-time items such as a $311 million gain on reinsurance recaptures and a $280 million impact from correcting an error in the second quarter's estimation of credit-derivative write-downs.

Ambac also said it will receive about $440 million in tax refunds because of recent legislation that will allow it to carryback 2008 and 2009 losses as far back as 2004. The tax refund will help the company's fourth-quarter surplus. Earlier this month, Ambac said it posted a third-quarter profit on big mark-to-market gains from credit derivatives, but it also reported growing insurance losses, particularly on mortgage-backed securities.

Japan Deflation Concern Rises Even as Growth Quickens

The acceleration of Japan’s economy to the fastest growth pace in more than two years masked a slide in prices of goods and services that threatens to temper the nation’s recovery. The domestic demand deflator, a measure of price levels that excludes the cost of imports, fell 2.6 percent in the third quarter from a year earlier, the most since 1958, Cabinet Office figures showed yesterday in Tokyo. At the same time, gross domestic product jumped 4.8 percent, the most since early 2007.

Sustained price declines threaten to curtail a corporate- profit rebound that’s already been insufficient to spur a rally in Japan’s shares this quarter. The report prompted Deputy Prime Minister Naoto Kan to say the government may outline an emergency-spending package as soon as today, adding that “I’m concerned we’re entering into a deflationary situation.” “This isn’t sustainable growth and the government knows it -- that’s precisely why they’re talking about the GDP deflator,” said Junko Nishioka, chief economist at RBS Securities Japan Ltd. in Tokyo. “On the face of it, 4.8 percent growth is a positive for the Democrats, but they’re not reading it as a reason to abandon their economic policies.”

A report today showed that demand for services unexpectedly fell for the first time in four months in September, a sign that the effects of government stimulus measures may be fading. The tertiary index, which captures 63 percent of the economy, slid 0.5 percent from August, the Trade Ministry said today in Tokyo. The median forecast of 23 economists surveyed by Bloomberg News was for a 0.2 percent gain. Kan said yesterday that the government should work with the Bank of Japan to tackle the price slump. The central bank has kept interest rates near zero to help rekindle growth.

Consumer prices in the world’s second-largest economy have fallen for seven straight months, undermined by the deepest recession in the postwar era. Deflation can undermine the economy by persuading companies and consumers to delay purchases in the anticipation of further price declines. It also increases the value of their debt.

“Deflation is great if you don’t have debt,” Nishioka said. “But debt drives most economic activity. Companies take out a loan to build factories or you get a mortgage to buy a house. Those burdens get heavier when incomes start to fall.” The yen’s 6 percent gain against the dollar in the past three months has exacerbated the price slump by making imports cheaper. Even after seven months of gains in factory output, about one third of Japan’s factories sit idle. The Democratic Party of Japan took power in September pledging to support households that have endured 16 months of wage declines and unemployment that climbed to a record in July.

“The biggest worry to us is that consumption growth has been too strong relative to incomes,” said Hiromichi Shirakawa, chief Japan economist at Credit Suisse Group AG in Tokyo, who used to work at the central bank. “It might be a decade before the job market returns to the level of health we had a year or two ago,” he said. “The number of jobs may recover but not wages. It’s very fragile.” A price war over jeans is a sign of that fragility.

Discount retailer Don Quijote Co. last month started selling jeans for 690 yen ($7.70), undercutting Aeon Co., Japan’s largest supermarket chain, which has been offering them for about $9. Fast Retailing Co., the operator of Uniqlo stores, started the battle in March with pairs at $11. “Japanese domestic demand is still dependent on price declines to grow,” said Naomi Fink, a strategist at Bank of Tokyo-Mitsubishi UFJ Ltd.

Without adjusting for prices, Japan’s economy shrank an annualized 0.3 percent last quarter, the sixth straight contraction. The Democratic Party of Japan has signaled that these nominal figures will play a greater role in its policymaking. “There’s been a tendency to focus on the price-adjusted figures,” Keisuke Tsumura, one of the DPJ’s top economic officials, said in an interview this month. “We’re going to try to strike a better balance in our decision-making that doesn’t ignore the nominal figures,” which he said better reflect the economy as households experience it.

The government’s heightened concern about deflation may put it at odds with the Bank of Japan. While the central bank last month forecast prices will keep falling through the year ending March 2012, Governor Masaaki Shirakawa has said deflation is unlikely to weigh on economic growth. The central bank won’t have room to raise the benchmark interest rate from the current 0.1 percent until at least the end of 2010, according to 15 of 16 analysts surveyed by Bloomberg News last month.

Still, most analysts said yesterday’s report suggests Japan will avoid a double-dip recession. Domestic demand, which includes consumer spending and business investment, contributed two-thirds of the country’s growth last quarter. In the previous three months, exports led the economy’s first expansion in more than a year. “The composition of these numbers was a lot more encouraging than the second-quarter numbers, said Richard Jerram, chief economist at Macquarie Securities Ltd. in Tokyo. “It wasn’t the net exports story, it was a swing in private domestic demand, which brings some promise of greater stability.”

Emergency $85 billion bailout of insurer AIG was botched, says report

The US government executed an emergency bailout of troubled AIG without sufficient planning, botching its initial $85bn (£50bn) effort to rescue the ailing business and further weakening the multinational insurer's financial position, according to a critical official report into last year's near collapse of the company. An inspector charged with overseeing the treasury's bail-out efforts concludes today that the intervention by the Federal Reserve and the treasury applied such onerous terms on a loan to AIG in September 2008 that it made matters worse.

The report also questions a decision to pay out $35bn in collateral to "make whole" all of AIG's counterparties on controversial credit default swaps, suggesting that government officials could have tried harder to squeeze concessions from top banks such as Goldman Sachs, Merrill Lynch and Barclays. The inspector general's findings could prove damaging to the US treasury secretary, Timothy Geithner, who was head of the Federal Reserve Bank of New York which led the AIG bailout efforts. The government intervened when AIG ran into trouble after Lehman Brothers collapsed.

The inspector, Neil Barofsky, who is answerable to Congress, says the government relied on an unsuccessful effort by Wall Street banks to raise a private sector rescue of AIG. When this failed, the Fed had no contingency plan and simply applied the private consortium's terms to an $85bn public loan which carried an interest rate of more than 11% and was in return for an 80% stake in AIG. "The decision to acquire a controlling interest in one of the world's most complex and troubled corporations was done with almost no independent consideration of the terms of the transaction, or the impact those terms might have on the future of AIG," says the inspector's report.

As AIG's position deteriorated further, the US government had to make two more interventions to prop up AIG, which was crippled by huge contracts written by a financial products arm largely run out of London. The counterparties in these credit default swaps received their total entitlements, avoiding a "haircut" that they would have taken if AIG went bust.

According to the inspector's report, the New York Fed asked AIG's eight leading counterparties to take discounts on their entitlements, but only one bank – UBS – offered to take a reduction of 2%. France's banking regulator, the Commission Bancaire, intervened by informing the Fed that it would be illegal under French law for two banks– Société Générale and Calyon – to take anything below their contractual entitlement. The inspector general says the banks received an amount "far above" the market value at the time for the swaps and were reimbursed without consideration of the government bailout, without which "they would likely have received far reduced payments as well as the indirect consequences of a systemic collapse".

Critics have suggested that the Bush administration was too soft on Goldman Sachs, the biggest counterparty to AIG, in part because of a close relationship between senior treasury officials and executives at the bank. The US treasury said a decision not to pay counterparties would have led to "defaults and cross-defaults" around the financial system.

General Electric Pursues Pot of Government Stimulus Gold

The financial crisis hasn't been kind to General Electric Co. Its stock has lost almost half its value, the government has stepped in to prop up its enormous financial arm, and sales have slumped in core industrial businesses. But Chief Executive Jeffrey Immelt now has his eye on a huge new pool of potential revenue: Uncle Sam's stimulus dollars. Mr. Immelt, a registered Republican, quips about the shift in thinking in the nation's corner offices: "We're all Democrats now."

GE has high hopes for the strategy. It says that over the next three years or so it could bring in as much as $192 billion from projects funded by governments around the globe, such as electric-grid modernization, renewable-energy generation and health-care technology upgrades. The company is just starting to see a payoff. Last month, for example, President Barack Obama announced $3.4 billion in government-stimulus grants for power-grid projects. About one-third of the recipients are GE customers. GE expects them to use a good chunk of that money to buy its equipment.

The government has taken on a giant role in the U.S. economy over the past year, penetrating further into the private sector than anytime since the 1930s. Some companies are treating the government's growing reach -- and ample purse -- as a giant opportunity, and are tailoring their strategies accordingly. For GE, once a symbol of boom-time capitalism, the changed landscape has left it trawling for government dollars on four continents. "The government has moved in next door, and it ain't leaving," Mr. Immelt said at the International Economic Forum of the Americas in Montreal in June. "You could fight it if you want, but society wants change. And government is not going away."

A close look at GE's campaign to harvest stimulus money shows Mr. Immelt to be its driving force. The 53-year-old executive supported the presidential campaign of Sen. John McCain, yet scored an invitation onto the President's Economic Recovery Advisory Board, led by former Federal Reserve Chairman Paul Volcker. Inside GE, he pushed his managers hard to devise plans for capturing government money. As part of that effort, GE has promoted policy proposals such as a government-backed power-grid modernization, and pressed the government to increase the size of stimulus grants for that purpose. It also has helped customers design projects and apply for government money, with the expectation that those customers will then buy GE equipment.

The initiative comes as a sluggish global economy is weighing on GE's core industrial businesses. Pursuing government contracts has become a centerpiece of its strategy around the globe. The company estimates $2 trillion in global infrastructure spending will get under way in coming years. It has announced a flurry of energy deals with foreign governments from Iraq to China. "I think we will do better than most on the stimulus," Mr. Immelt told analysts in April. He declined to elaborate on the effort for this article.

The strategy is not without risks, say two GE executives who have been critical of the plan. Government policy could change. Stimulus projects could roll out more slowly than GE expects and generate less revenue than forecast. GE could fail to win competitions to supply hardware and services to companies and public entities that receive stimulus dollars. GE isn't in agreement with the Obama administration on some proposals. Its GE Capital financial unit, which contributed nearly half of its earnings in recent years, received government backing for its debt when the credit markets seized up last fall.

Now GE is lobbying against proposals that would separate GE Capital or its industrial-loan company from the parent company. More regulation on its finance division seems inevitable. The company also is opposed to health-care proposals that would result in $40 billion in fees on health-care device makers such as GE. GE, whose businesses range from washing machines and lights bulbs to aircraft engines, wind turbines and nuclear reactors, has long done business with the U.S. government.

Over the years, the company has been associated with Republican politics. President Ronald Reagan, voice of GE ads and host of the GE Theater television show from 1954 to 1962, said the views he encountered at GE helped transform him into a free-market conservative. Former CEO Jack Welch, who handpicked Mr. Immelt to succeed him, was a prominent supporter of several Republican presidential candidates. Nancy Dorn, the current head of GE's government-relations office in Washington, served in the administrations of Mr. Reagan and both Mr. Bushes.

Mr. Immelt's push to corral federal money began even before Mr. Obama took office. In December, with the economy in a skid, Mr. Immelt was under fire from shareholders. Advisers to Ecomagination, the company's green-technology-development initiative, gathered at GE's boardroom in midtown Manhattan. Among other things, the group discussed how an Obama stimulus plan might shape the nation's energy future. Mr. Immelt concluded that the company needed to capitalize on the surge in government spending. According to two people present at the meeting, Mr. Immelt told the group that business people needed to support the Democrats' stimulus package.

By January, Mr. Immelt had become a leading corporate voice in favor of the $787 billion stimulus bill, supporting it in op-ed pieces and speeches. Reporters who called the Obama administration for information on renewable-energy provisions in the legislation were directed to GE. As the bill worked its way through Congress, GE lobbyists pressed for grants, tax cuts or rebates aimed at businesses GE is engaged in, including provisions worth more than $80 billion for energy projects, appliances, health-care information systems and wind farms. GE would have to compete with rivals for a share of these grants.

When the stimulus package was rolled out, Mr. Immelt instructed executives leading the company's major business units "to put together swat teams to get stimulus money, and [identify] who to fire if they don't get the money," says a person who heard him issue the instructions. In February, a few days after President Obama signed the stimulus plan, GE lawyers, lobbyists and executives crowded into a conference room at GE's Washington office to figure out how to parlay billions of dollars in spending provisions into GE contracts. Staffers from coal, renewable-energy, health-care and other business units broke into small groups to figure out "how to help companies" -- its customers, in particular -- "get those funds," according to one person who attended.

The group put together a colorful two-page fact sheet about how the stimulus plan works, then printed hundreds of copies for GE salespeople to distribute to customers, including local governments and power companies. The fact sheet said GE would be involved with setting national standards and energy-transmission policy. The sheet also said that GE could help regional utilities and governments win federal stimulus money earmarked for making the power grids more efficient.

Separately, Mr. Immelt got an invitation to serve on the President's Economic Recovery Advisory Board, which would afford him access to the president's economic inner circle. The bipartisan board is composed of industrial, finance and union leaders, and Mr. Immelt has become one of the administration's advisers on jump-starting manufacturing and creating jobs. "We think he is an important voice...we talk about energy being a place where America can produce jobs in the manufacturing space," says White House Chief of Staff Rahm Emanuel. "He has those interests, and they match ours. But we didn't come to them because of him."

At the board's first public meeting in May, Mr. Immelt and fellow board member John Doerr, a Silicon Valley venture capitalist and prominent Democrat, led a discussion of the advantages to business of a proposal to make companies pay for greenhouse-gas emissions. The board voted to adopt that position. "This was an early example of a group of business leaders willing to say that a clean-energy policy that put a price on carbon could create major opportunities for the economy if done right," says Austan Goolsbee, staff director and chief economist on the recovery board. A so-called cap-and-trade bill will likely not be considered by Congress until early next year.

One plank of the stimulus bill provides for energy grants for the development of "smart grids" -- sophisticated transmission systems in which power consumption and demand is carefully monitored to conserve energy. GE says it, along with others, urged the Department of Energy to increase its maximum energy grant 10-fold, to $200 million. Then GE helped some 100 customers, mostly power providers such as Florida Power & Light, to apply for money. GE General Counsel Brackett Denniston III says the company frequently provides expertise to governments and clients, and that its assistance on government-grant applications does not ensure its clients will win the resulting contracts.

GE makes a wide array of equipment that its customers can use in conjunction with smart grids. GE sells appliances, for example, designed to make use of power at quiet times of day or night, when rates could be cheaper. Of the 100 smart-grid grant recipients Mr. Obama announced last month, one-third were GE clients. GE declines to say what portion of the $3.4 billion in government money went to its customers. Its executives have told analysts that GE stands to reap up to $500 million in contracts from every smart-grid project built in a city with a population of more than one million.

GE has said that the state of Florida and partners plan to invest $800 million by 2014 to upgrade its power grid, and that the bulk of the equipment would come from GE. "If we can do this in Miami, we ought to be able to do this in 100 more large cities across the country," Steve Fludder, vice president of GE's Ecomagination green-technology initiative, told analysts at a conference in May. GE has said that its goal is to increase its Ecomagination revenues to $25 billion by 2010, from $18 billion in 2008. Ecomagination products accounted for about 17% of revenues of GE's industrial businesses, Mr. Fludder said.

GE spent $7.55 million lobbying in the second quarter, a 34% increase from the year-earlier period and more than any other single company, according to federal data compiled by the Center for Responsive Politics. GE does not disclose how much revenue it has gleaned from the government stimulus program. So far, the returns appear to have been modest, relative to GE's $182.5 billion of revenue in 2008. Nine months after Mr. Obama signed the stimulus bill, about half the federal money has been allocated. Most of it went to initiatives like individual tax cuts and aid to states, which don't directly benefit GE's businesses.

Mr. Immelt said last month that GE won't see a bigger impact on its revenues from stimulus spending until the current quarter, at the earliest. "We have a couple billion dollars of orders already into it," he said. "That's not just the U.S. It's China and other countries." The effort could be hampered if Congress or the administration, anxious about rising unemployment and a growing deficit, decides to cut back on stimulus programs or redirect money toward job-creating measures less beneficial to GE, such as employer-tax credits. GE shares have rallied in November on signs that troubles in the company's finance unit could be easing. But some analysts question the company's projections for added revenue from stimulus projects.

"We remain very skeptical on the stimulus, overall," says Scott Davis, an analyst at Morgan Stanley. He says GE's estimates of what it could reap from the stimulus programs is "way too high." Mr. Davis and other analysts at Morgan Stanley say they expect only $30 billion of the stimulus plan's $275 billion infrastructure spending to flow this year. Asked last month if its government-contracting estimates were too optimistic, Mr. Immelt replied: "We'll see. We'll keep the target out there."

Hands warns governments on banks

Guy Hands, head of private equity house Terra Firma, warned on Wednesday that unless governments pushed banks to restructure $7,000bn of leveraged loans that are due to mature by 2014, the US and Europe could face the “Japanese problem” of zero growth. “Unless the banks address this problem you will end up with the Japanese problem,” Mr Hands said on the sidelines of the Super Investor conference in Paris. “Japan could afford no growth because of its declining population, but it is not an option for the UK and America.”

Mr Hands’ comments come as the Terra Firma boss is negotiating with Citigroup to restructure the £2.6bn debts of EMI, the music group that is his private equity group’s biggest investment and one of the US bank’s largest single leveraged loans. Previous studies have estimated that private equity groups are sitting on about $400bn of leveraged loans that need repaying in the next five years. But Mr Hands said his $7,000bn figure included all forms of private equity, such as loans for property deals.

The Terra Firma chairman said banks were split between those not bailed out by governments, which were dealing with bad debts quickly, and those that had taken money from the state, which were avoiding taking writedowns. “It is those banks that have the most government support that are the most reticent to act,” he said. “You need to ask banks to do their bit, but as we’ve seen with EMI that is incredibly difficult to do.” The US government has a 34 per cent stake in Citi. He cited Royal Bank of Scotland’s £300bn portfolio of “non-core loans” as an example of the problem. “That takes a government decision, it is not a decision that any loan officer can make,” he said.

Terra Firma’s recent offer to put £1bn of fresh equity into EMI in return for Citi writing off £1bn of its debt has been rejected by the US lender, leaving negotiations deadlocked on one of the last deals from the leveraged buy-out bubble. “The Citi discussions [on EMI] are about how much pain each side can take,” said Mr Hands, one of the UK’s best-known private equity bosses. “The governments have done an amazing job of winning the war, by stopping the financial system from going under, but now they need to win the peace.”

In his speech earlier on Wednesday, Mr Hands outlined his view of how a smaller, more humble private equity industry would emerge from the crisis. “I believe the leveraged buy-out private equity model can be fixed but it is going to be a painful process,” he said. “The days of making a quick buck in private equity are over. “In the future the private equity industry will be smaller and more humble, but it will be considerably better at delivering long-term value.”

Bank of America, UBS, JPMorgan Sued Over Derivatives

Bank of America Corp., UBS AG and JPMorgan Chase & Co. were sued by a California public utility over claims they rigged sales of municipal derivatives and shared illegal profits through kickbacks. The lawsuit, filed by the Sacramento Municipal Utility District, is based on federal and state antitrust claims. It alleges Charlotte, North Carolina-based Bank of America and more than a dozen other banks conspired to pre-select winners of municipal derivative auctions, coordinated their pricing, and accepted kickbacks disguised as fees from co-conspirators.

The allegations resemble those made by a U.S. grand jury in New York last month, according to the lawsuit filed Nov. 12 in federal court in Sacramento. CDR Financial Products Inc. founder David Rubin and two employees of the Beverly Hills, California- based company were indicted for allegedly accepting kickbacks on investments sold to local governments. CDR is also named as a defendant in the Sacramento case.

The banks engaged in “allocating customers and markets for municipal derivatives, rigging the bidding process by which municipal bond issuers acquire municipal derivatives, and conspiring to manipulate the terms that issuers received,” according to the lawsuit. The charges against Rubin and the CDR employees were the first to result from a more than three-year investigation into bid-rigging in the municipal bond market. The probe is continuing and has already drawn in some two dozen banks, insurers and local government advisers.

Derivatives are unregulated financial instruments linked to stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather. Shirley Norton, a Bank of America spokeswoman, didn’t immediately return a call seeking comment after regular business hours yesterday. SMUD, which provides electricity to Sacramento County and part of Placer County, is the sixth-biggest publicly owned utility in the U.S. by customers served, according to its Web site.

Insurers Face $23 Billion Loss on Commercial Property

U.S. life insurers, a group led by MetLife Inc. and Prudential Financial Inc., may lose as much as $22.6 billion on investments in commercial real estate through 2011, Fitch Ratings said. Losses on investments in apartment buildings, offices, shopping malls and other commercial real estate will begin to increase in the next 6 months to a year as rents decline and vacancies increase, said Fitch Senior Director Andrew Davidson. Life insurer losses on commercial real estate have been “virtually nil” so far, he said. “It will be more of a 2010 and 2011 issue,” Davidson said in an interview today. “It will put some stress on the capital positions as they realize the losses.”

Life insurers held more than $450 billion in commercial loans and mortgage-backed securities at the end of 2008, Fitch said in a related report. The delinquency rate on U.S. CMBS rose to 4.01 percent at the end of October, almost seven times what it was a year ago, Moody’s Investors Service said yesterday. MetLife has recorded three straight quarterly losses and Hartford Financial Services Group Inc. has lost money since June 2008 as investments that include those backed by commercial and residential mortgages dropped in value. New York-based MetLife and Prudential have said commercial mortgage defaults will climb in the next year.

“Losses in our commercial mortgage portfolio are going to accelerate over the next 18 months,” Bernard Winograd, executive vice president of Newark, New Jersey-based Prudential, said in an August conference call. “The fact that there have been very little in the way of delinquencies so far should not be taken as an indication that there won’t be losses.” MetLife’s Chief Investment Officer Steve Kandarian said in June the insurer would have “some issues” related to the holdings. “The worst is to come,” he said in an interview with Bloomberg Television. “Typically there’s a lag between when the economy softens and when the defaults actually occur.”

The credit crisis has driven $138 billion worth of U.S. commercial properties into default, foreclosure or debt restructuring, according to New York-based Real Capital Analytics Inc. Commercial real estate prices have plunged almost 41 percent since October 2007, the Moody’s/REAL Commercial Property Price Indices show. The dollar value of loans dropped 56 percent for office properties and 40 percent for apartment buildings, the Washington-based Mortgage Bankers Association said in a Nov. 5 statement. Loans for malls and shopping centers fell 62 percent and hotel loans declined 46 percent.

Life insurers’ underwriting profits and improved capital levels will mitigate losses related to commercial real estate, Davidson said. “They’ve got plenty of capital and they continue to have operating earnings, so in that regard we think the losses will be manageable,” he said. “They’ll be able to fill the holes that develop.”

California faces a projected deficit of $21 billion

The legislative budget analyst's projection, to be released Wednesday, threatens to send Sacramento back into gridlock and force more broad cuts to state programs.

Less than four months after California leaders stitched together a patchwork budget, a projected deficit of nearly $21 billion already looms over Sacramento, according to a report to be released today by the chief budget analyst.The new figure -- the nonpartisan analyst's first projection for the coming budget -- threatens to send Sacramento back into budgetary gridlock and force more across-the-board cuts in state programs.

The grim forecast, described by people who were briefed on the report by Legislative Analyst Mac Taylor, comes courtesy of California's recession-wracked economy, unrealistic budgeting assumptions, spending cuts tied up in the courts and disappearing federal stimulus funds. "Economic recovery will not take away the very severe budget problems for this year, next year and the year after," said Steve Levy, director of the Center for Continuing Study of the California Economy.

In fact, after two years of precipitous revenue declines, the new report projects relatively stable tax collections for the state, said those who were briefed. But that won't stop the deficit from climbing to nearly $21 billion. Gov. Arnold Schwarzenegger, who will present his next proposed budget to Californians in January as he begins his last year in office, started sounding the alarm last week. "I think that there will be across-the-board cuts again," he said at a San Jose news conference.

The task in 2010 could be even harder than it was this year, when record deficits and cash shortfalls drove California to issue IOUs for only the second time since the Great Depression. Lawmakers have already cut billions from education, healthcare and social services while temporarily hiking income, sales and vehicle taxes. "I can't think of any good solutions," said Assemblywoman Noreen Evans (D-Santa Rosa), who chairs the lower house budget committee.

The current budget year accounts for $6.3 billion of the deficit, the nonpartisan analyst projects. Prisons spending will outstrip what has been budgeted by more than $1 billion, and K-12 schools were underpaid by $1 billion under the complex formula that governs education funding, the report says. Another $14.4 billion of the deficit is for the fiscal year that begins next summer, say those briefed on the report. The governor's next budget will have to account for both years.

The state Department of Finance in August predicted a shortfall of at least $7.4 billion for fiscal 2010-11. But California's financial picture has darkened considerably since then, largely because the shaky summer budget pact relied heavily on borrowing, fiscal tricks and overly optimistic projections. It assumed receipts of nearly $1 billion from the federal government for Medi-Cal that the analyst questions. Another $1 billion was assumed from the sale of a quasi-public workers' compensation agency that has stalled. Next year's budget fight is expected to be as contentious as this year's. Republicans vow to block new taxes; Democrats say they are through with program cuts.

Powerful interest groups are already girding for battle. "There is no more to cut from our schools," California Teachers Assn. President David Sanchez said Tuesday. "There is no more meat on this bone. . . . The next step is amputation." In higher education, Chancellor Charles Reed of the Cal State University system said this month that he will plead for $884 million in funds from Sacramento next year. The University of California will ask for $913 million more for its 10-campus system, President Mark Yudof has said.

"If ever there was a time to fight for and invest in the institution best positioned to power this state from recession, now is that time," Yudof said in a statement. UC students, meanwhile, are coping with a staggering 32% fee hike. California's finances have been so bad that the governor's finance director, Mike Genest, told a budget forum in Washington last week that back in February he had combed through the U.S. Constitution to research whether California could legally declare bankruptcy -- or revert to some kind of territorial status. (Neither was realistic, he determined.)

The state's financial problems predate the current recession and the gimmicks used to paper over the deficit, experts say. Year in and year out, state government spends roughly $10 billion more than it collects in tax revenue. Political divisions in Sacramento, where support from both parties is necessary to pass a budget, have repeatedly stymied efforts to plug that hole. The task probably won't be easier next year as various interests try to muscle one another to the sidelines.

Some have even drafted potential ballot measures to aid themselves in the budget fight and are preparing to collect signatures in an effort to place the initiatives before voters. Among the ideas: raising tobacco taxes, curbing public pensions, repealing corporate tax breaks passed thisyear and last, splitting the tax rules for commercial and residential property, reducing the legislative votes needed to pass a budget and strengthening the firewall around local government and transportation money. "There's a lot of people putting chess pieces on the board right now," said Jon Coupal, president of the anti-tax Howard Jarvis Taxpayers Assn. "The question is which of those chess pieces will be moving."

America's Newest Land Baron: FDIC

In the waning days of the Great Recession, the federal government is still jumpstarting the economy and propping up financial markets. It is also trying to sell Dresden Heights, a failed condo development on a noisy freeway ramp next to a Motel 6, a Waffle House and a Do-It-Yourself Pest Control.

For more than a year, the Federal Deposit Insurance Corp. has been seeking a buyer for 36 partially built condos it inherited from a high-flying, short-lived Atlanta bank. The agency has been fending off vandals, haggling with architects and uncovering the developer's blunders, all in a bid to dispose of this condo project, just one of the 2,554 foreclosed assets dumped onto its books. "These are properties with a bad story," says Jim Gallagher, a senior official in the FDIC's Division of Resolutions and Receiverships. "What we're trying to sell is something that is rundown or not completed or has some property damage." The financial crisis started with Americans buying homes they couldn't afford. It is ending with the government struggling to sell buildings it never wanted.

In the past two years, the FDIC has taken over 150 failed banks. In the process, it has seized more than 5,000 houses, subdivisions, buildings, parcels and other foreclosed assets. The current backlog of property stuck on the agency's books, with an appraised value of $1.8 billion, ranges from an $18,700 clapboard home with stained carpets in Birmingham, Ala., to a $1.7 million mountainside lodge with a heated driveway in Steamboat Springs, Colo. Taxpayers will be grappling with this flotsam for years to come, one example of how the crisis will linger long after the economy begins to revive. At a recent FDIC auction in Atlanta, the agency offered a four-unit condo building it had already sold once before -- after the savings-and-loan crisis two decades ago.

These days, it takes the FDIC on average six to eight months to sell a property. Dresden Heights, tied up with unpaid bills, a lawsuit and complex right-of-way questions, is among its toughest prospects. The project was the brainchild of Quantum Homes and its chief executive, Ramsey "Jim" Salahat. In March 2006, just as Atlanta's housing market was peaking, Mr. Salahat took out a $3.78 million, 18-month loan from Main Street Bank in Covington, Ga., to purchase and prepare 5.3 acres abutting an interstate entrance ramp.

The developers brought in a crane, knocked down soaring oak trees, installed sewers and laid out two short roads, Heights Way and Quantum Lane. They planned 80 residential units and seven buildings. At the groundbreaking in May 2007, Mr. Salahat and Quantum President Eyal Livnat posed for photos, wearing white hardhats and digging red Georgia soil with shovels festooned in blue ribbons. They threw a cocktail party, serving wine, roast beef, quiche and cookies.

"Future homebuyers are quickly reserving space at Dresden Heights...so interested homebuyers should act fast to ensure they have a home at this great community," Mr. Salahat said in a news release afterwards. The release quoted Deanna Helie, a "prospective home buyer" who attended the event, as saying: "When this area begins to grow, I want to be in on that growth at an early point." Ms. Helie, who lives adjacent to the Dresden Heights property, said she was talking about the neighborhood only, and stopped by out of curiosity, not to shop. She wondered about the wisdom of building homes next to a pest-control outlet. "I was thinking, 'This isn't going to fly,'" said Ms. Helie, a computer programmer.

A few days after the groundbreaking, Mr. Livnat signed a two-year, $6.75 million loan from Alpha Bank & Trust, a startup bank in nearby Alpharetta, Ga., to finance construction of the first three buildings. Two dozen customers, most of them first-time home buyers, put down $500 to $1,000 deposits on the condos, which started at $194,900. The developers told the early buyers they would likely be able to move in within a year, according to Kristy Jeffries, who at the time was Quantum's saleswoman.

In early 2008, work on the project slowed, Ms. Jeffries recalls. People started asking for their money back, "and the builders weren't giving it to them," she says. In her office, located in the basement of a model home, she started receiving calls from disgruntled subcontractors complaining they hadn't been paid. She says one unhappy supplier repossessed Quantum's construction trailer, which still contained file cabinets with records of potential buyers. That spring, Mr. Salahat closed Quantum's headquarters in a lavish Atlanta office complex. He moved the company into a cramped, low-budget space behind a chiropractor's office outside of town, where Ms. Jeffries says she went for her paychecks.

The last time Ms. Jeffries saw Mr. Salahat was over a Tex-Mex meal in May 2008, when the developer told her the company was going bankrupt. Former associates say he has moved to Jordan. Neither they nor the FDIC could provide contact information. Mr. Salahat's listed phone numbers in the Atlanta area have been disconnected. During a brief interview on his stoop, Mr. Livnat, Quantum's former president, declined to discuss details of the Dresden Heights project. "It was an unfortunate time to start a company," Mr. Livnat said. "Things were at a peak, and it went down quick." Mr. Livnat was skittish about answering the door, and he said he is worried the FDIC or creditors might come after him.

Alpha Bank foreclosed on the three partly finished buildings a year after Messrs. Salahat and Livnat broke ground. On May 6, 2008, a bank representative stood outside the Dekalb County courthouse and offered the property for sale. No one was willing to beat the bank's $4.692 million minimum. Alpha Bank now owned Dresden Heights. The buildings sat exposed to rain, sun and wind through the summer of 2008, prompting bank officials to sign an agreement with McGuire Properties Inc., of Kennesaw, Ga., to finish construction. The company is run by George F. Nemchik, Jr., who was also an Alpha Bank shareholder, according to his attorney and Ms. Jeffries. Mr. Nemchik didn't return calls seeking comment.

Alpha Bank retained Ms. Jeffries to sell units. When she went to pick up her paycheck one day in October, a bank executive told her the lender was on the brink of collapse. He suggested the FDIC might want to keep her on as a sales agent for Dresden Heights. She demurred. "I think that property is cursed," she says now. The American government came to own Dresden Heights on Friday, Oct. 24, 2008, about six weeks after the collapse of Lehman Bros. Georgia regulators closed Alpha Bank and turned it over to the FDIC. That weekend, Stearns Bank of St. Cloud, Minn., took over Alpha's branches. It acquired just $39 million of the $354 million in assets. The FDIC took possession of the rest, including Dresden Heights.

The FDIC inspector general's post-mortem blamed Alpha Bank's failure on "management's aggressive pursuit of asset growth concentrated in high risk" residential real-estate development and construction loans. Former Alpha Bank chief executive Joe Briner, now a consultant with a corporate-turnaround firm in Atlanta, didn't return calls seeking comment. The FDIC wanted the property sold quickly, despite a series of obstacles, including hundreds of thousands of dollars in liens filed against Dresden Heights by building-material suppliers and McGuire Properties, the company that was finishing construction. If enforced by a court, any potential buyer would have to cover those bills before taking possession.

In January, the FDIC's outside property-management firm gave the listing to Atlanta real-estate broker Rob Jordan, a 40-year-old who had spent 10 years as a commercial banker before joining his father in the family firm. These days, Jordan Co. does virtually all of its business selling foreclosed commercial properties. Mr. Jordan and his colleague, David Walmsley, pulled the county records on Alpha's construction loan, a routine step. They stopped cold at the surveyor's description of the property put up as collateral. "Said tract of land contains 6,776 square feet," the documents said of the first parcel. The other two parcels were similarly small.

Messrs. Jordan and Walmsley realized that Alpha Bank and now the federal government owned the three buildings and the land immediately beneath them -- but not an inch more. "What about the sidewalks? The stairs? The stoops?" asks Mr. Jordan. "They're all on someone else's property." The brokers checked with the county and confirmed that even the two small streets running through the subdivision belonged to someone else. That someone else was BB&T Corp., a Winston-Salem, N.C., bank. BB&T had bought Main Street Bank, which made the original loan to Quantum that allowed the developer to buy the Dresden Heights land. When Quantum went bust, BB&T foreclosed on that land and put it up for sale for $1 million.

Rifling through court records, Messrs. Jordan and Walmsley discovered that Quantum had signed an easement allowing passage between the two properties. But it wasn't clear if the agreement would be legally binding on future owners.
The murky right-of-way made the sales job far more difficult. The FDIC would have to inform potential buyers there was no guarantee they could gain access to their property without trespassing. The brokers next sought to obtain the building plans, vital documents for anyone hoping to finish the development. In January, Mr. Jordan called Bill vonHedemann of Niles Bolton Associates, the principal architect on the project, to ask for copies. Mr. vonHedemann declined, politely. The developers, he said, owed his firm more than $60,000 in fees.

Anyone who wants the 85 or so computerized drawings will have to pay for them, he told Mr. Jordan. "We don't give the plans away," Mr. vonHedemann said in an interview. Mr. Jordan didn't worry, initially. Alpha Bank should have had plans on file and regularly sent an agent to the site to check progress. But the brokers found no evidence Alpha had kept such records. Meantime, the property was beginning to deteriorate. Over the winter, the outside pipes froze. In March, thieves broke into a model unit and stole the refrigerator, the range and the dishwasher. The FDIC boarded up the ground-floor windows on all of the townhouses, changed the locks, stowed the air conditioners in the garages and hired a full-time security service.

Messrs. Jordan and Walmsley fielded nearly a dozen offers, but none was close to the $2.8 million asking price. By May, the brokers worried the FDIC was shooting too high. The FDIC ordered two new appraisals, a process that took almost five months. The brokers put off would-be bidders by saying the FDIC was undertaking "internal adjustments," an intentionally vague phrase intended to keep shoppers interested without responding to offers. McGuire Properties, the company that had agreed to finish the Dresden Heights construction on behalf of Alpha Bank, dropped its liens on Aug. 17 in the face of a federal law making the FDIC immune to such claims. Instead, McGuire sued the FDIC in federal district court. McGuire contended that after seizing Alpha, the agency had directed the builder to continue work on the condos, and reneged on a promise to pay. The company demanded $653,014 plus interest.

In court filings, the FDIC denied the main allegations and asked the court to force McGuire to cover the government's legal costs. The two sides are in settlement talks. In September, the agency cut Dresden Heights's asking price 25%, to $2.1 million, and the brokers called the serious prospects. One repeat bidder was 39-year-old Ho Hyun Chung. Mr. Chung moved from Seoul to the U.S. in 1996 to study business. He stayed to work for the U.S. cell-phone unit of LG Group, a South Korean conglomerate. Frequently up late on conference calls with headquarters, Mr. Chung became hooked on TV infomercials touting DVDs and books that promised riches through foreclosed real-estate. "I bought most of them," he says.

In 2007, as the real-estate market was tanking, Mr. Chung quit LG and started a business with his wife. Their niche: Buying unfinished foreclosed townhouses and completing them. He says he owns 42 units in 11 properties around the Atlanta area, including five townhouses he bought from the FDIC in December. He says he makes money on some, and loses on others. Mr. Chung spotted Dresden Heights on the FDIC Web site. He liked that it was inside the perimeter beltway and near two universities. He figured he could make a good return if he put no more than $1.5 million into finishing the project and then sold the units for $130,000 to $145,000 each, generating almost $5 million in gross revenue. It's a plan, he says, that depends heavily on the federal government's $8,000 first-time homebuyer tax credit. The credit, just extended by Congress, expires at the end of April. "If that goes, I don't know how the market will react," he says.

In October, almost a year after the FDIC seized Dresden Heights, the FDIC and Mr. Chung signed a sales contract giving him 30 days to conduct due diligence. Neither side would disclose the price. Only then did Mr. Chung's lawyer notice that the FDIC's buildings were islands surrounded by BB&T's land. Mr. Chung acknowledges the FDIC disclosed the information, but says he "didn't quite understand" the problem until his lawyer raised it. "I need to clean that up first," he says. He also wanted to make sure the person who buys the BB&T land signs an agreement that allows for the development and sale of the three buildings. This month, he asked the FDIC for an extension on his 30-day contingency period. The FDIC turned him down, and the agreement expired.

Bank of England splits three ways over policy for first time since 2008

The Bank of England's Monetary Policy Committee is split three ways over how to tackle the worst recession since the 1930s, minutes of their meeting showed today. While all nine members of the MPC voted to hold interest rates at a record low of 0.5pc, there was disagreement over the radical policy of printing money, or quantitative easing. The decision to increase the scale of the programme by £25bn to £200bn was backed by seven members of the committee, including Governor Mervyn King, the minutes show. But David Miles, a new member of the committee, sought a £40bn increase while the Bank's chief economist, Spencer Dale, voted to hold the amount at £175bn.

The three-way split is the MPC's first since August 2008 and underlines the challenges facing the MPC as it grapples with how to pull the economy from recession without sparking inflation. The MPC also discussed the possibility of lowering the rate it pays banks to keep reserves with it in an effort to encourage lending to the wider economy. Last week's Inflation Report from the Bank surprised markets with the strength of their forecasts for growth and inflation given that the economy is still losing jobs and lending to companies and households is weak. "Overall then, the MPC may not yet be done – much will depend on the data between now and February," said Jonathan Loynes, an economist at Capital Economics. "But any tightening of policy is still a long way off."

Mr Dale argued that increasing QE, which is designed to hand financial institutions cash by buying Government bonds, or gilts, from them, "might result in unwarranted increases in some asset prices that could prove costly to rectify." Mr Miles, who joined the MPC from Morgan Stanley, said that pumping even more money into the economy would "provide greater insurance against the downside risks to growth and inflation arising from constrained credit supply."

Pension deficits in Britain underestimated by $450 billion

Lloyds Banking Group and Royal Bank of Scotland, the state-backed lenders, are among a raft of large European companies underestimating the size of their pension deficits by a combined €300bn (£268bn, $450 billion). Lloyds' stated pension obligations are €14.2bn shy of the real size of the deficit, while RBS's are €13.3bn behind, according to research from equity research house AlphaValue. British Airways, which is pursuing a merger with Spanish airline Iberia, boasts the third highest shortfall at €10.5bn. The size of BA's pension deficit is being monitored by the airline's shareholders as Iberia has retained the right to walk away from the agreed merger pending the outcome of a triennial review at the UK carrier's pension fund.

Other companies boasting sizeable differences between actual and stated pension obligations included Barclays, BT Group, GlaxoSmithKline and HSBC, according to the research. BT revealed last week that its final-salary pension scheme deficit had more than doubled in the past six months from £4bn to £9.3bn. The change came as a result of movements in bond yields and inflation expectations, as well as changes to accounting regulations. AlphaValue said many of the 430 companies monitored underestimated the true value of their pension deficits by assuming a low level of wage inflation and by adopting a high discount rate, a measure used to value pension funds' liabilities.

The research house said 31 companies had underestimated their deficits by 40pc or more, with UK firms among the worst offenders. "More than one-third of 2008 pensions obligations – some €1,100bn – are recorded at UK companies, as this is where the largest companies operate with the largest defined-benefit commitments. The bulk of the "non-accounted-for" pension deficit is also with UK corporates, especially the banks, as they use rather high discount rates compared with non-UK peers," said Pierre-Yves Gauthier, a director at AlphaValue.

Companies are believed to be attempting to reduce stated pension deficits by scaling back projected wage rises and maximising the discount rate. Last year, average wage inflation fell from 3.7pc to 3.6pc, while discount rates grew from 5.38pc to 5.57pc. AlphaValue said the "spread" helped save European companies about €51bn in 2008. Mr Gauthier said many companies had made efforts to correct valuations this year, but warned that volatile market conditions made it important to find consistent measurements, above all on discount rates. Official figures from companies' 2008 accounts show pension deficits at the European companies growing 22pc last year to €280bn. The AlphaValue research showed an additional €300bn of unrecognised deficits, the equivalent of 9pc of shareholders' equity.

Michael Panzner: Commercial Real Estate Is A "Tsunami Unfolding"

Michael Panzner is bearish, and you should listen.
Why?
The 25-year veteran of the global stock, bond, and currency markets was one of the few who called the crisis before it happened, with a book aptly titled "Financial Armageddon."
Today, Panzner calls a V-shaped recovery "ridiculous," says commercial real estate is a bubble sure to burst, and is fearful that there's far too much speculation on commodities, risky stocks and emerging markets. In short, he says "the world is a riskier place and will continue to stay that way going forward."
We caught up with Panzner at a panel on risk management sponsored by QFinance. Some notes from our conversation:
On recovery, Panzer says it's "a protracted process" but "talk about a 'V' bottom is ridiculous." He also said "talk about a jobless recovery is laughable, especially in the context of the U.S. being some 70% reliant on the consumer:"
In some respects the system is more broken than it was before. From my perspective at least the economic model of the banking system -- the operating model is essentially broken. Securitization doesn't work. The biggest supplier of funds and the biggest customer to the banking sector is the Federal Reserve. In some respects the whole concept of too big to fail has been complicated by the fact you have institutions that are now too connected to care. There's a hubristic element that remains from the crisis of the past two years.
On dealing with the financial crisis by spending:
[We've] learned the wrong lessons in terms of how to deal with the crisis. Before we had this notion that people could slice and dice risk and make it go away. The new version of that is the fact that large amounts of publicly created debt will somehow make the problems of large amounts of old, privately-created debt go away, which is a little bit of a non sequitur.
On the coming commercial real estate crash:
Commercial real estate seems to be the accident waiting to happen. In my mind at least there is no doubt...in fact it seems like a deja vu moment in terms of the way it's playing out. We're getting reassurances here that it's all going to be okay, it's this sort of contained phenomenon...it's very reminiscent in my mind of what took place with sub-prime and the failure to acknowledge that it was a broader problem -- an institutional problem in terms of credit, in terms of risk taking. It seems like there's a bit of an instant replay going on with commercial real estate. People are thinking 'well, it hasn't happened yet, so it's not going to happen.'
That's the old Hurricane Katrina line of reasoning. From what I can see it's a tsunami unfolding and it's going to be a real train-wreck over the next two to three years for the banking sector. I don't think there's any way around that issue. Zero.
Another deja vu moment for Panzner is government debt. The same problems of securitization and derivatives apply: faulty assumptions, faulty models with limited data, and over-confidence.
"They're assuming debt levels can go up forever, without putting that in any sort of reality context." But that rules out the black swan, which is "what happens if people don't want to buy your debt."
Panzer thinks we may see hyper inflation as the share of U.S. outlays relative to the deficit are about 40%. "It may not be such a good idea -- even though the Krugmans of the world think it is -- to spend unlimited amounts of money without thinking through the potential consequences."
On the next financial bubbles:
I'm a very long term bull on gold, however I believe that gold and commodities more generally, the short dollar trade, the long equity trade are all part of this gigantic risk play that is propagated by this huge amount of cheap money being pumped into the system...I would be looking for these things to correct, perhaps violently.
He adds: "The first real uptick you get in the dollar you'll see elephants running through a revolving door."
Panzner says gold is the perfect example. People say it's a safety hedge, but why are bonds not selling off and why are emerging markets going up? "If you look at that they're all moving together then you get a much clearer, coherent picture. It's another bubble, an echo bubble or whatever you want to call it."
Besides gold, Panzner counts oil, basic commodities, stocks, emerging markets -- and other riskier assets -- as the stuff of speculation and over-investment.
It's an Orwellian universe. People keep making non sequeters and everyone else shakes their heads and says 'yeah, that's okay' and no one is standing back and saying 'wait a minute, that doesn't make any sense at all.' People are saying these things and acting on them but not thinking thinking them through and saying 'wait a minute, this doesn't make sense.

Goldman On The Dollar Carry Trade: "A 20% Reversal In Either 3 Months Or 3 Days"
by Tyler Durden

As the decoupling between cause and effect continues: i.e., the economy and the stock market, more and more pundits focus on the dollar carry trade as the primary culprit for market appreciation. With the US market flat for the year when indexed for the decline in the dollar, the entire rally has been one big window dressing to prop up Obama's confidence boosting propaganda. Yet the entire rally, aside from the unique technical peculiarities underpinning it (short squeeze, low volume/high momentum algo participation) has been carried on the back of the dollar's decline: take away the concept of importing inflation at all costs (which is what Bernanke is happy to continue doing) and US deflation would have been rampant by now, proving the Fed's plan to liquefy the capital markets to be a disaster. As such, the only thing that allows the "rally" to continue, is the willingness of the Rest of the World to fund not only the skyrocketing US budget deficit, but the Chinese trade imbalance, courtesy of the yuan-dollar peg.

The rally will come to an abrupt end when one of two things happens: i) the Fed gives an indication it wants investors to stop chasing risky assets (likely not for at least 5 years) and ii) the rest of the world realizes that America has no leverage whatsoever, with its crumbling economy, and its loose monetary policy which as prominent Chinese figures have already determined, is currently causing asset bubbles worldwide (yet which the Chairman is unable to see). Possibility ii has a much greater probability of occurring, yet if and when it does, will be dependent in great extent on the future of the dollar carry trade.

Nouriel Roubini has already pointed out the great danger posed by every single trader in the world being short the dollar. As we saw on Monday, one word out of place by Bernanke, and the reversal will be disastrous. Below we present the thoughts from Goldman Sachs, which, as expected, is much more sanguine about the impact and the participation in the carry trade. To Goldman, the dollar value is merely a function of the US economy's weakness. Ironically, Goldman has been pumping up the strong economy story for much of H2, until recently when even 85 Broad has reversed its opinion.

While Goldman's observations are not surprising, the question emerges as to how the firm is positioned now to make the higher amount of money from a macro picture, as very few trade on company-specific alpha: courtesy of banks like Goldman, every asset class has become one big beta bucket. If Goldman is wrong, which it likely is in this case, the impact would be rapid and dramatic: as Goldman itself notes: a 20% reversal which would come in either 3 months or 3 days. Let's recall Goldman's stance on oil last summer to see just how spectacularly wrong the world's most riskless hedge fund can be in its "policy" guidelines.

Factors Driving Dollar Weakness besides Dollar-Funded Carry Trades

There has been a lot of focus recently on the extent of Dollar-funded carry trades contributing to the decline in the USD. The IMF in a report prepared for the recently concluded G-20 Finance minister's meeting cited ‘In addition to foreign funds moving into emerging market equities, led by expectations of higher growth, there are indications that the U.S. dollar is now serving as the funding currency for carry trades. These trades may be contributing to upward pressure on the Euro and some emerging economy currencies.'

We find the argument of Euro benefiting from this particular dynamic somewhat challenging though, given the minute rate differentials here. But overall, there are carry trades funded in USD and other commentators have expressed their worries over a new ‘carry bubble' emerging. While pinning down precisely the extent to which speculative Dollar funded carry trades are taking place is not an easy task, we can point to a few other factors behind Dollar weakness so far this year. Simply put, the Dollar's decline so far does not seem too out of line, especially when you consider that the US is still cyclically one of the weakest economies around.

While there has been a pick-up in investment in higher yielding currencies and assets, there is a distinction to be made between speculative carry trades and investments made on the basis of stronger EM fundamentals. It is hard to draw the line where investment activity becomes a speculative bubble but we do not think that we are in the midst of a 'carry bubble' at the moment. Yes, inflows into EM assets have accelerated rapidly over the last several months but this has also arguably been led by improving fundamentals in these countries in general.

US equity fund flows into EM markets have broadly tracked the widening growth gap between EM countries and the US. We use a simple measure of real GDP growth in EM countries minus US growth to track the latter, which shows that the EM-US growth differential had peaked in 3Q of 2008, bottomed in 1Q 2009 and has since widened out again over the last 2 quarters . Plotting this EM-US GDP differential versus US equity fund inflows into EMs, there does not seem to be any significant divergence. The point being that EM equity flows so far have been underpinned to a certain extent by relatively stronger recovery prospects.

Other factors underpinning Dollar weakness include hedging asymmetries. We have most recently discussed this in our latest November FX monthly publication. In a nutshell, this refers to the likelihood that overseas investors in US assets appear to be FX hedged to a greater degree than US investors of foreign assets. As a result, a rally in risky assets tends to result in Dollar selling to maintain hedge ratios.

Finally, part of the Dollar weakness trend observed so far since the crisis has also been due to the ongoing normalization in markets. This has been well described in a recent speech by Chairman Bernanke: ‘When financial stresses were most pronounced, a flight to the deepest and most liquid capital markets resulted in a marked increase in the dollar. More recently, as financial market functioning has improved and global economic activity has stabilized, these safe haven flows have abated, and the dollar has accordingly retraced its gains.' Indeed, our GS USD broad TWI has retraced to a large extent but even now is still slightly stronger than the levels of autumn last year.

USD-funded Carry Bubble vs Bubbles from Importing US Monetary Policy

Thus while there are Dollar-funded carry trades and certainly other cyclical factors behind the Dollar's weakness, we do not think we are seeing a speculative ‘carry bubble' for now. The difference being a 20% strengthening in the Dollar upon a reversal, over say 3 months as opposed to 3 days for the latter.

There is also a difference between a Dollar-funded carry bubble and asset price bubbles from importing loose US monetary policy. There is certainly a case to be made of certain parts of the world currently experiencing rapid asset price inflation, as a consequence of the accommodative monetary policy of the US. Hong Kong comes to mind, importing the low US interest rate policy with its currency peg, despite having a different economic backdrop and real exchange rate appreciation pressures. Domestic asset price inflation is thus one of the release valves in such an instance, while maintaining an undervalued nominal currency. Same goes for Singapore with its managed exchange rate basket and imported low nominal interest rates. But this is largely a consequence of the adopted exchange rate regimes of these countries, where one way to ease asset price inflation would be to allow more domestic nominal currency appreciation.