December 16, 2010

2011 – Could It Be A Repeat of 2010?

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 5:38 PM by Robert Barone

Many pundits in the business media are signaling that the economy will perform much better in 2011 than it did in 2010.  Here are 9 reasons, forecasts, if you will, why 2011 will look a lot like 2010.

U.S. economic growth will remain anemic. There is still a small probability that there will be a double dip in 2011. The recent policy shifts by the Obama Administration to continue the Bush era tax rates and to reduce the social security tax on individuals for a year makes a double dip less probable, albeit this is occurring at the expense of fiscal discipline, something the bond vigilantes clearly do not like.  David Rosenberg, the Gluskin-Sheff economist, has stated several times in his daily blog that he thought 2010 consumption has been buoyed by folks who had stopped paying their mortgages but remained in those homes “rent free”.  Rosenberg has opined that a high percentage of what used to be their mortgage payments likely found their way into consumption.  So, a significant rise in “Strategic Defaults”, as discussed above, will likely have a similar impact in 2011.

But it is because of the job situation that economic activity will continue to be anemic. Job creation is all but non-existent.  The headline monthly jobs report emphasizes the number of jobs created.  That number is estimated by the Bureau of Labor Statistics (BLS) from a survey of large businesses called the “Establishment Survey”.  We’ve all come to realize that, in this economic environment, it is the small businesses that are suffering most.  So the “Establishment Survey” of large business appears to be biased to the upside.  The “Household Survey”, on the other hand, comes from a large sample of U.S. households and is probably a much more accurate gauge of the health of the labor market.  In November, the number of jobs in this survey fell by 173,000 after falling 330,000 in October.  According to BLS, in the 12 months ended in November, the number of employed people in this country rose from 139.132 million to 139.415 million, or by a grand total of 283,000.  Furthermore, we’ve come to look at the BLS data with a jaundiced eye.  According to John Williams of Shadowstats.com, who is an expert in the way BLS measures the data, “the overstatement of the level of payrolls as of November, 2010, is about 610,000 jobs” (see Shadow Government Statistics – Commentary No. 337).  Mr. Williams also indicates that “BLS continues regularly to overestimate growth in payroll employment by roughly 250,000 jobs”  each month due to its biased assumption that in today’s economy, small businesses, which are not in its samples, are actually adding jobs, an assumption that we know is not accurate.

In addition, the policies pursued by all levels of government for the past two decades have finally caught up to small businesses, the major job creator in the U.S.  With reduced income and cash flows, many such businesses can no longer bear the tax, fee and administrative burdens imposed.  In many localities, it is a nightmare to fulfill all of the government imposed requirements, file all of the paperwork, deal with the bureaucracy, and pay the fees just to open a small business.  Then there is the ongoing plague of fees, restrictions and regulations, many of which have arisen because of a few scam artists like Bernie Madoff, or simply because of a failure on the part of the regulators in the first place.  The American people are bearing a great burden in terms of cost for the actions of a very few.  And instead of really fixing the issues with straightforward solutions, every individual and every business is simply taxed or regulated in the name of political correctness.  This applies all the way from airport security to the newest set of Dodd-Frank regulations, to the daily pronouncements of federal and state bureaucracies in the form of ever more burdensome rules.

Big businesses have their own bureaucracy as anyone who has ever tried to call one knows. The internal staff is paid to cope with all of the rules, regulations, and burdens.  With small businesses closing in record numbers, the market penetration of big business is rising.  With small business being choked to death, even in an anemic underlying economy, like that in the U.S. today, big business has been able to prosper.  The overall economic pie in 2011 will be about the same size as it was in 2008 when measured by GDP, but big business’ share of it will have grown significantly.   This view goes a long way toward explaining large cap corporate profitability and rising equity prices along side of high unemployment and overall anemic private sector growth.

 

Housing will continue its downward spiral.  In 2011, foreclosures won’t be about those who lost their jobs or just can’t afford the payments anymore.  “Strategic defaults” will mount and accelerate in 2011.  The trend is already beginning.  It is no longer a stigma to walk away from an underwater mortgage, even if you can afford the payments.

 

Mortgage ‘Put Backs’ will become a national issue. FNMA and FHLMC purchased tons of low or no doc loans from Wall Street that likely were not entirely “truthful”.  When Congress finally addresses these two bankrupt behemoths, it will be hard to ignore this issue and stick the losses onto the taxpayers, especially after the results of the just past elections.  The large Wall Street institutions, which sold the majority of these “fraudulent” loans to FNMA and FHLMC, are likely to be held responsible.  Remember, it was Wall Street’s greed that led to the housing bubble.  Now that greed is going to come back to haunt them.

 

Europe’s debt crisis will intensify. First it was a bailout for Greece; now it is Ireland.  Portugal and Spain appear to be on the bond vigilantes’ radar.  When you hear the prime ministers of these countries publicly proclaim that they do not need a bailout, you know one is imminent.  For the European Union, Portugal can probably be rescued in the same manner as Greece and Ireland.  But Spain is simply too big.  Germany’s prime minister, Angela Merkel, is pushing the idea that by 2013, any government aid will have to be accompanied by a haircut for the bondholders.  If the bond vigilantes attack Spain, which is likely, that idea will have to be moved up to 2011.

 

State and local government finances remain in crisis. This is likely to go on for several more years.  Already, these governments are raising taxes on businesses and individuals which can’t be good for job creation.  These governments are large consumers of business products and services.  Last month, John Chambers of Cisco Systems shocked Wall Street by forecasting poor sales for this business segment.  These government entities must lower costs (layoffs) or raise taxes, or both.  All conceivable scenarios for state and local finances imply a much lower level of business activity.  In addition, 2011 will witness a significant increase in the number of local government defaults.

 

Debt Concerns will hit the U.S. 2011 could be the beginning of the end of the U.S. dollar as the world’s reserve currency. As I have blogged previously (Wow! That’s a Lot of Debt, TheStreet.com, May 5, 2011, and What Happens to the Cost of U.S. Debt if Interest Rates Rise? Minyanville.com, November 29, 2010), the debt situation in the U.S. is as ugly as some of the European weaklings.  In addition, there is another shoe that has yet to drop, but will when interest rates rise – the cost of the debt. As a result of the almost certain expansion of the deficit due to the tax “compromise” now being considered by the lame duck Congress, there has been a rise in interest rates.  This has happened despite the fact that it has been the Fed’s expressed intent to keep rates low.  Could it be that the bond market is more powerful than the Fed itself?  Could it be that bondholders are getting concerned about the rising deficit and are beginning to demand higher returns?  Could 2011 be the beginning of higher debt costs despite (or perhaps because of) what the Fed does?

 

Precious metals likely to continue to rise in value. If U.S. economic growth remains anemic, higher deficits (now a reality given the tax “compromise” the lame duck Congress is now ”enhancing”).  This implies a weaker dollar and a rise in the dollar price of most commodities (including precious metals).  If, on the other hand, U.S. recovery is robust, the world economy will thrive and the prices of most natural resource inputs (including precious metals) will rise due to demand.  But China could be the fly in the ointment.  Rule #9 of Bob Farrell’s, (former Merrill Lynch economist), 10 rules for investors is: “When all the experts and forecasts agree – something else is going to happen”.  So, what can possibly happen?  Answer: A dramatic slowdown in China’s growth.  If that were to occur, demand for natural resources and manufacturing inputs would fall, and, of course, the markets would over react to the downside.  Because of its rapid growth, many view the Chinese centrally planned economy as efficient, much like some viewed Russia’s in the 60s and 70s. But, history hasn’t produced a single centrally planned economy (including that currently in the U.S.) that has worked efficiently.  Lately, there have been many commentators who have pointed out imbalances in China’s economy (empty  buildings, a real estate credit explosion, rapidly rising real estate prices, rapidly rising consumer prices …).  It is inevitable that sooner or later China’s economy will misfire.  Will that be in 2011?  I don’t know – but precious metals investors ought to be cognizant of this risk.

 

Federal deficit will rise, not fall, in 2011. The actual 2010 deficit exceeded $1.5 trillion.  As a result of the tax “compromise” which is now being debated and “enhanced” in Congress, 2011’s deficit will likely exceed 2010’s.  In a previous blog (What Happens to the Cost of U.S. Debt if Interest Rates Rise? Minyanville.com, November 29, 2010), I indicated that the four major social categories in the federal budget (Medicare/Medicaid, Social Security, Income Security, and Federal Pensions) along with Defense/Wars and Debt interest consume 86% of that budget.  All of these items will have significant upward pressures in 2011 and beyond.  The recent elections will only begin a long process of getting the structural deficits under control, and the success of that is far from a certainty.  The “compromise” reached between the Democrats and Republicans in the lame duck Congress is clearly a budget buster, and that has implications for interest rates (rising) and the dollar (falling).  The bond vigilantes have already reacted as interest rates rose rapidly after the “compromise” announcement.

 

The Stock Market will remain range bound. Twelve years ago, the S&P 500 index was right where it is today.  Given the state of the economy, that performance is likely to continue.  While the large multinational corporations may see modest profit growth, much of this will likely be at the expense of small businesses which will continue to suffer from over taxation, over regulation, and rising input costs.  And without jobs and the lack of availability of easy credit, consumption is not likely to be robust.

Just as in 2010, while the economy may do poorly, big business will do just fine.  The stock market will be held back by a lack of job growth, all of the federal, state and local and household debt issues, debt issues in Europe, a continued slump in housing prices, mortgage defaults and “put backs”, and a weakening dollar.  Buoying it will be decent large cap corporate earnings.

Robert Barone, Ph.D.

December 9, 2010

The mention of securities, precious metals or other types of securities in this article should not be considered as an offer to sell or a solicitation to purchase any securities mentioned.  Please consult an Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals.  Investments in precious metals and similar securities or commodities are subject to risks.  It is important to obtain information and understand these risks prior to investing.

 

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

 

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

 

 

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December 1, 2010

Wow-II! That’s A Lot of Interest!

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 5:42 PM by Robert Barone

Recent events in Europe have once again focused the markets on the huge overhang of debt in the high debt European economies with Ireland now effectively joining Greece on life support from the EU and IMF.  Can Portugal (Spain) be far behind?  (Most Americans and Germans would have a fit if they knew how much of the IMF commitments were borne by them!)  During that first European debt crisis last spring, I blogged about the level of debt in the U.S. (see “Wow! That’s a Lot of Debt!” at TheStreet.com 5/21/10).  Now, with QE, QE2, and trillion dollar structural deficits as far as the eye can see, I wonder how many people recognize the potential devastating costs of the national debt as deficits continue, especially if interest rates start to rise as many pundits believe is fairly imminent.

This is a blog about the cost of the national debt.  But, to set the table, let’s look at some data.  The national debt currently stands at $13.7 trillion, and, under the most optimistic Congressional Budget Office (CBO) projections for 2015, it is projected at $17.4 trillion (based on 4.9% GDP growth between now and 2015).  More likely, unless economic growth improves dramatically, the debt will rise to $20 trillion, perhaps $22 trillion in the next five years.  The Federal Budget is nearly $3.5 trillion (23.9% of GDP) and CBO projects a Federal Budget of $4.2 trillion (22.8% of GDP) in 2015.  Tax collections for 2010 are expected to be $2.1 trillion, of which $894 billion are from income taxes.  CBO projects total taxes to rise to $3.7 trillion by 2015 (an 11.7% annual growth rate), and for income taxes to rise to $1.9 trillion (16.1% annual growth rate!).  Clearly, such projections occurred prior to the recent elections. Today, for every dollar spent by the Federal Government, nearly $.39 is borrowed.  USDebtClock.org indicates

Six Largest Federal Budget Categories

Budget ($Mill) % of Total Budget
Medicare/Medicaid $787,463 22.6%
Social Security $698,455 20.0%
Defense/War $688,017 19.7%
Income Security* $425,429 12.2%
Interest on Debt $200,340 5.7%
Federal Pensions $196,893 5.6%

* Includes Supplemental Security Income, Earned Income Credits, Unemployment Compensation, Nutrition Assistance, Family Support, Child Nutrition, Foster Care, Making Work Pay.

that the six budget categories shown in the table account for nearly 86% of the Federal Budget.

The six categories shown account for nearly $3 trillion of spending and are 140% of total tax collections indicating the nature and extent of the structural deficit.  A few of these six categories have become “sacred cows” with any politician or would be politician attempting to “fix” any of the four “social” categories (Medicare/Medicaid, Social Security, Income Security, and Federal Pensions) subject to vicious political attack.  It also appears that these four are also subject to fierce upward spending pressures as the population ages, the recession continues, and federal employee wages remain significantly above those available in the private sector (and rising!).  As long as the U.S. continues to fight two wars and must defend itself against the war declared on it by the jihadists, upward pressure on the defense budget will continue.  That leaves Interest on the Debt.

The website USTreasuryDirect.gov has a wealth of data concerning the national debt.  As of October 31, the official debt was $13.689 trillion consisting of $8.497 trillion of marketable debt and $5.192 trillion of non-marketable.  Debt held by the public (including foreigners), which consists of most of the marketable debt plus a few minor items (like savings bonds), was $9.07 trillion.

The remainder of this paper investigates what happens to the cost of the debt if interest rates rise?  It isn’t a simple answer because the debt matures issue by issue on widely different dates.  If a maturing issue, for example, has a coupon higher than current market conditions require, the total cost of the debt would fall.  So, changes in interest rates take time to work their way through the debt maze.  To analyze what happens to the cost of the debt, I made the following assumptions: a) the shifts in the yield curve would be parallel shifts; b) a maturing issue would be reissued to its original term (for example, an issue that matures on 11/15/10 that was issued on 11/15/2000 (i.e., a 10 year Note) would be reissued on 11/15/10 at current market interest rates to mature 11/15/20); c) the marketable debt ($8.497 trillion) is a close proxy for the debt held by the public ($9.07 trillion).  While the “cost” of the $13.689 trillion is a number in the $325 billion range on an annual basis, the real cost of the debt is the cost of the portion held by the public because that is the net amount of interest to be paid out; the rest is just intra-governmental transfers.  Some may argue that the budgets of those agencies must reflect the interest that has to be paid, but for this analysis, I have used the “net” debt concept.  The existing marketable debt (Bills, TIPS, Notes, and Bonds) has a weighted average maturity of 4.9 years and a current cost of 2.41%.  The base yield curve used is the yield curve for Treasuries and the yield curve for TIPS on 11/15/10 as shown in the following table:

11/15/10 Yield Curves

Treasuries TIPS
1 month .12%
2 months .13%
3 months .14%
6 months .19%
1 year .29%
2 year .53%
3 year .81%
5 year 1.51% -.06%
7 year 2.16% .34%
10 year 2.92% .87%
20 year 4.01% 1.68%
30 year 4.38% 1.79%

The table below shows the percent change (from current costs) in the cost of the marketable debt in 1, 3, 5 and 10 year periods using parallel shifts in the base yield curve of between 0 and 700 basis points (bps).  As the table shows, the longer the yield curve stays where it is (or goes lower), the better it is for the cost of the existing debt.  For example, under the constant yield curve scenario (0 bps change), because the issues maturing have a higher coupon than newly issued debt, the cost of the existing debt falls.  So, if the 11/15/10 yield curves exist for the next year, the cost of the debt would fall by 5.2%, or approximately $10.6 billion.  And, over 10 years, the annual cost reduction would be quite significant.  Under the parallel shift of 100 basis points scenario, the cost of the existing marketable debt rises 7.3% (approximately $14.9 billion) after 1 year.  Under this scenario, things stabilize and actually improve between the 5 and 10 year marks.  However, as the table shows, as rates rise more than 100 basis points, things deteriorate.  For example, at a 200 basis point rise, 5 years out the cost of the existing debt will have risen 37.4% (approximately $76.5 billion).  So, if the economy begins to experience inflation, or if we simply cannot place the maturing debt without higher coupon yields, the cost of the existing debt becomes a significant issue.  Using the 5 year column, the cost of the existing marketable debt for rises of 300 and 500 basis points is 66.0% ($135.0 billion) and 123.2% ($251.9 billion) respectively.

Percent (%) and Dollar Changes (Bill $) in the Cost of Existing Marketable Debt

Under Parallel Shifts in the Yield Curve

Yield Curve Shift 1 Yr 3 Yr 5YR 10YR
0 bps -5.2% 

-$10.6

-14.3% 

-$29.2

-19.8% 

-$40.4

-30.9% 

-$63.2

100 bps 7.3% 

$14.9

8.1% 

$16.6

8.8% 

$18.1

6.5% 

$13.3

200 bps 19.8% 

$45.5

30.6% 

$62.5

37.4% 

$76.5

44.0% 

$90.0

300 bps 32.3% 

$66.0

53.0% 

$108.4

66.0% 

$135.0

81.5% 

$166.6

500 bps 57.3% 

$117.2

97.9% 

$200.2

123.2% 

$251.9

156.4% 

$319.8

700 bps 82.3% 

$168.3

147.6% 

$291.9

180.3% 

$368.8

231.3% 

$473.0

Of course, this does not tell the whole story, as the U.S. continues to run significant budget deficits, and each added dollar of debt results in increased interests costs.  The CBO has projected the national debt at $17.35 trillion in 2015.  That is $3.68 trillion more than now exists.  Given the current deficit estimate of $1.27 trillion for fiscal year 2011 (which began October 1) after $1.56 trillion of red ink in fiscal 2010, and an economy clearly in low gear, the CBO number is clearly optimistic.

In the table below, I show the change in the cost of the marketable debt using the CBO $17.35 trillion of total debt, and adding more realistic $20 and $22 trillion columns (I note that on June 9th, the Treasury projected the 2015 deficit at $19.6 trillion).  Besides the assumptions used in the table for the existing debt, the following assumptions were added to create the estimates for higher levels of debt: a) all of the new debt created is marketable; and b) the term structure of the total marketable debt would not change from what it is currently.  As can be seen from the table, deterioration in the cost of the debt is rapid, even if interest rates rise only slightly.  For example, even at a parallel shift in the yield curve of only 100 basis points, at $20 or $22 trillion of debt, the cost rises 63.8% ($130.5 billion) or 81.2% ($166.0 billion) from current levels.  The cost of the debt, which is currently 5.7% of the Federal Budget, would rise to 11.1% under CBO projections and to 13.4% or 15.1% of the Federal Budget under the $20 trillion and $22 trillion scenarios at the more “normal” interest rate levels represented by the 300 basis point shift row in the table.  While that is daunting, the rest of the table is truly terrifying, especially if the Fed’s QE programs end up putting the U.S. economy into a 1970’s type inflation.

Percent (%) and Dollar Changes (Bill $) in the Cost of 2015 Marketable Debt

Under Parallel Shifts in the Yield Curve

Yield Curve Shift CBO ($17.35 trillion) $20 trillion $22 trillion
0 bps -4.0% 

-$8.1

7.4% 

$15.1

16.0% 

$32.7

100 bps 40.8% 

$83.5

63.8% 

$130.5

81.2% 

$166.0

200 bps 85.6% 

$175.0

120.2% 

$245.8

146.3% 

$299.3

300 bps 130.4% 

$266.6

176.6% 

$361.2

211.6% 

$432.6

500 bps 219.9% 

$449.7

289.4% 

$591.8

341.9% 

$699.3

700 bps 309.4% 

$632.8

402.2% 

$822.5

472.3% 

$965.8

It is a fine line the Congress and Federal Reserve is walking.  Given the structural nature of the deficits and the difficulty of slowing or reversing defense costs or the costs of the “social” categories, even small upward changes in interest rates toward “normality” will exacerbate the deficit and economic growth issues.

Robert N. Barone, Ph.D.

November 29, 2010

The mention of securities or types of securities in this article should not be considered as an offer to sell or a solicitation to purchase any securities mentioned.  Please consult an Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals.

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

 

October 28, 2010

QE2: More Harm Than Good

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:24 PM by Robert Barone

With voters up in arms about unconscionable federal and state deficits and likely to change the ability of the federal government to add even more “stimulus” in the next Congress, all eyes are now on the Federal Reserve (Fed).  QE2 (Quantitative Easing 2 – government speak for money printing) has been promised by various Fed documents and Federal Open Market Committee (FOMC) member public speakers, including Chairman Bernanke himself.  The equity markets have responded.  Priced in is a large stimulus with the expectation that it will lead to an increase in the anemic rate of economic growth, and, hopefully, a lowering in the rate of unemployment.  Any disappointment is likely to have a significant impact on the equity markets.

But, beyond the transitory impact on the equity market, is QE2 good public policy?  A good, question, especially since QE1 did not produce any measurable economic growth.  Some folks argue that QE1was a success in the sense that it saved the credit markets from complete collapse and likely saved several large financial institutions.  However, the issue today isn’t the functioning of those markets.  In fact, new debt issues have no trouble finding buyers today.  The issue today revolves around an economy that cannot find traction.

Hope?

So, what does the Fed hope to accomplish by bloating up its already pregnant balance sheet?  It is pretty clear that the economy is in a liquidity trap.  That is, like the 1930s, the banking system already has an extremely high level of excess reserves and there appears to be no demand for borrowing.  On the contrary, because consumers have too much debt, they are now foregoing consumption and borrowing despite historically low interest rates (Mohammed El-Erian’s “New Normal”).  Thus, on a monthly basis, we continue to see significant loan contraction.  The actual implementation of QE2 (the buying of bonds and notes in the open market) adds reserves to the banking system, and lowers interest rates on the part of the yield curve in which the purchase operations take place, with, perhaps, some trickle down to the rest of the yield curve.  Given the level of excess reserves already in the system, the Fed certainly can’t be hoping that these actions will spur loan growth.  And, given the already historic lows in interest rates, they can’t be foolish enough to think that the lowering of rates by a few basis points will have a significant impact.  Then, what can the Fed possibly be hoping for in this round of money printing?

Another Asset Bubble?

Asset inflation is one possibility.  And the announcement of QE2 has been, to date, successful in inflating equity prices.  The hope here appears to be that rising equity prices will cause a “wealth effect” – an increase in consumer confidence and more spending because of the perception of rising equity values.  All past studies of the “wealth effect” that I am aware of suggest that its impact on consumption is quite small compared to other policy tools.  Unfortunately, all of the other tools have already been completely deployed.

Inflation Expectations?

QE2 also increases the potential money supply, resulting in rising inflation expectations, and, ultimately resulting in a weakening dollar relative to other currencies.  In other blogs, I have discussed the “race to the bottom” in the world’s currencies (see “How the U.S. Should, But Won’t, Handle Job Creation”, Minyanville, 10/6/10).  Given the very strong deflationary pressures in housing and from record levels of unemployment, it appears that the Fed hopes to combat such pressures by influencing inflation expectations.  Again, the impact here doesn’t appear to be very robust.

Trade Deficit Reduction?

Finally, it seems that the Fed, by its QE2 announcement, must believe that a weaker dollar will improve the trade deficit and ultimately bring jobs back to the U.S.  This appears contrary to what Treasury Secretary Geithner says about a strong dollar, but there just isn’t any other possible interpretation.  Because other countries react by lowering the value of their currencies to protect their export industries, there doesn’t appear to be any benefit here, either.

Negative for Jobs

There are potential intermediate and long-term negative consequences of QE2.  One possible negative impact is on jobs, and is contrary to the objective of the QE2 program.  First, many companies have invested in plant and equipment overseas, so their commitment isn’t reversible in the short-term.  Second, most companies look for a business environment where they are comfortable, i.e., where there is visibility into the future tax and regulatory environment, something that the U.S. currently lacks.  Third, and what isn’t widely recognized, is that a weak dollar policy (QE2) drives dollars (capital) to other countries in the attempt to protect its value.  As dollars flow to places with more stable tax and regulatory environments, it is invested there, thus enhancing economic growth there, not here.  The dollars that do return to the U.S. are invested in very short-term investments (U.S. Treasury Bills and Notes) which, by their nature, are not invested in long-term projects (i.e., they finance current U.S. government deficits), and, therefore, do not create jobs.

Negative for Consumers

The intermediate and long-term impacts of QE2 is also likely to be negative for consumers.  Ever lower interest rates on consumer deposits and along the yield curve continues to remove income from savers and investors and transfers it to the large financial institutions and to the large publicly traded companies.  The lower cash throw offs from savings and investments causes lower levels of consumption.

In addition, the weaker dollar, as a result of QE2, has two more negative impacts on consumption:

  • A weaker dollar means higher commodity prices in dollar terms (note the rise in the prices of gold, industrial metals, oil, and agricultural commodities since the announcement of QE2) which are inputs in the manufacturing process.  If they can, manufacturers will pass along these higher costs to consumers in the form of higher prices.  In this case, consumption will be negatively impacted unless consumer incomes rise faster than the prices (not likely with high unemployment levels).  In the more likely case that most of the increase in input costs cannot be passed on because of consumer resistance, corporate margins get squeezed.  Again, a negative result for economic growth.  Furthermore, some of these commodities are more important than others, e.g., oil and food.  After 40 years of dependence on foreign oil, we should be well aware of the negative impact on consumption of rising gasoline prices.
  • Then, of course, there is the direct impact of a weaker dollar on the prices of imported goods.  Despite Walmart’s commitment to lower prices, because they are a huge importer of foreign manufactured goods, as the dollar weakens, even their prices will have to rise.

More Harm than Good!

Most of the large multinational firms can deal with a weaker dollar and new regulations.  For them, because they have significant sales in other currencies, a weaker dollar is beneficial to their overall dollar denominated income statements.  But small, domestic businesses are another story.  In this economy, they cannot pass on increases in their input costs due to a weakening dollar.  Furthermore, rising taxes and fees from federal, state, and local governments (e.g., the costs of Obamacare) and added regulations (e.g., new IRS 1099 reporting requirements) are overwhelming small businesses.  Small businesses create the vast majority of jobs in the U.S.  The weaker dollar implied by QE2 will further impact the already reeling small business sector.  There is only one conclusion to be drawn:  QE2 is likely to do much more harm than good.

Robert Barone, Ph.D.

October 25, 2010

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89521, Phone (775) 284-7778.

 

October 20, 2010

Fool’s Gold 3: The Empire Strikes Deals

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 5:59 PM by Robert Barone

On October 8, 2010 California Governor Arnold Schwarzenegger signed a compromise budget that closed the $19 billion dollar state budget shortfall, 100 days overdue.  Three days later, Ron Diedrich, acting director of the California Department of General Services, proclaimed he had completed a deal to sell 24 government buildings to a consortium called California First, LLC.  The deal, in which California will lease-back the space, was completed for the sum of $2.3 billion, one billion of which will be used to pay off the current debt on the buildings, and rest going to the state’s general fund.  Is this good public policy?  Is California selling off the family jewels to meet structural budget shortfalls?   Should other states follow California’s lead?

Assets sales are not a new idea.  In fact, recently there have been many such announcements.  The UK government plans on selling $25 billion worth of assets including the Channel Tunnel rail link and a bridge over the Thames River. The Irish government, on July 23rd, announced plans to sell $115 billion of assets which include airports, railroads, ports, and the national television service.  And, the Russians outlined plans to sell $29 billion of minority stakes in state owned companies.  Closer to home, in December 2008, Chicago leased out parking meter rights for 75 years for $1.2 billion to a group called Chicago Parking Meters LLC (Morgan Stanley, Abu Dhabi Investment Authority, and Allianz Capital Partners).

Let’s take a closer look at the Chicago meters deal.  In December of 2008, Mayor Daley said, “This proposed agreement, which will provide the city with a one-time payment of just under $1.2 billion comes at just the right time.  This use of metered parking proceeds will give us the flexibility to address our worsening economy, protect our city’s finances and taxpayers, and keep investing in our city’s human needs over the next few years.”  Here is where the money went: $ 400 million went into a long-term reserve fund which they claim will earn them $40 million (that’s 8% a year!).  $325 million of the sale went to balance Chicago’s budgets through 2012, (in 2009 Mayor Daley claimed the city had annual structural deficit of $200 million),  $100 million went to support human infrastructure projects, and the last $324 million to another reserve fund called Budget Stabilization, which can be tapped at the Council’s will.  Sounds good right?

Not so fast said Alderman Scott Waguespack in a recent Bloomberg news release. “Chicago gave up billions of dollars in revenue when it announced in 2008 that it leased Morgan Stanley its 36,000 parking meters, the third-largest system, for $1.15 billion to balance its budget.”  Waguespack was one of five to vote against the deal, (there are 50 on the Council).  He could be right.  Chicago Parking Meters’ revenue rose 48% to $18.3 million for the quarter ended June 30, 2010.  Based on new projections, the lease deal could yield more than $11.6 billion over the 75 years to Morgan Stanley and Partners.  And it could rise even higher depending on rate increases the partnership has the right to make over the next five years, (increases after that must be approved by the Council), and CPI adjustments the partnership can make over the lifetime of the lease.  The office of the Inspector General concurs with the Alderman, and believes that, “the city’s chief financial officer, who negotiated the agreement, failed to calculate how much the system would be worth over 75 years.  The present value of the contract was $2.13 billion, more than the $1.15 billion the city received.”  With the Mayor’s recent retirement announcement, this deal could leave a bad taste in Chicagoans’ mouths for years to come.

In January 2010, Los Angeles City Council released $500,000 in funds to finance a feasibility study on leasing 41,000 parking meters.  Mayor Bloomberg of New York also likes this idea and assigned Deputy Mayor Stephen Goldsmith to look into it.   Milwaukee is proposing selling its water supply, and in Louisiana and Georgia, airports are being put on the block.  Warren Buffett said in Congressional testimony that he is worried about how municipalities will pay for public workers retirement and health benefits, suggesting that the federal government will eventually have to step in.

Returning to California, it looks like Governor Schwarzenegger agrees with Warren Buffett.  He stated, “There are similarities in what’s happening in Great Britain and what’s happening in California.  We’ve got to go and spend less money. I think governments have promised people too much.”

So did California sell off the family jewels?  To answer that question let’s take a closer look at the transaction.  California First, LLC., a group made up of Hines (a privately owned real estate firm with $23 billion in assets and offices worldwide) and an international private equity firm, Antarctica Capital Real Estate, offered $2.33 billion for the 24 buildings on 11 parcels of land.  California First will lease back the space to the state for 20 years at market rates.  The state will also have the right to buy back the buildings at anytime.

Governor Schwarzenegger has said, “This sale will allow us to bring in desperately needed revenues and free the state from ongoing costs and risks of owning real estate.”   But, while the state does exit the risks associated with real estate ownership, it subjects itself to long term lease liabilities.  A report from the Associated Press stated that the deal would end up costing the state $5.2 billion in rent over the next 20 years.  This was confirmed by a study from Beacon Economics which looked at the rent over 30 years.  A recent report from the California State Analyst’s office entitled, “Should the State Sell its Office Buildings?”, stated that California originally bought office buildings to save money.

The problem here is that such short term revenues do not change the long term structural deficits. Schwarzenegger appears to understand the long term structural problems of California recently saying, “We’ve got to roll back the pensions. And that’s not just in California but all over the world.”  But it doesn’t appear that the California Legislature has accepted that there has been a paradigm shift, a “New Normal” as Mohamed El-erian of PIMCO puts it.  Instead, the Legislature appears to have decided to band-aid the current budget shortfall, using assets sales as a bridge loan. The Legislature hopes that the economy will recover, and return to the so called Old Normal.  Robert Kurtter, a managing director at Moody’s said, “We view these asset sales as 1-shots…that create structural budget imbalances in future years, but that may be necessary actions to bridge the time gap until revenue stabilization or growth returns.”  These types of one time budget maneuvers were cited in a recent downgrade of Arizona’s debt by Moody’s.

In reality, using such asset sales as bridge financing will only work if the structural deficits are addressed.  That is, the budget needs to be in balance before the state’s assets are depleted.  This can be done by a) reducing spending and fixing such things as the state pension plan, b) by raising taxes, or c) combinations of the two. It’s a roll of the dice with low odds to assume a return to the Old Normal.  One thing is for sure.  Whether or not spending is reduced, look for the next Califorina legislature to raise taxes on it citizens and corporations.

 

Robert Barone, Ph.D.

Joshua Barone, Managing Partner

October 15, 2010

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

 

October 7, 2010

Job Creation: It takes the Right Environment

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 4:29 PM by Robert Barone

Job creation is probably the most important issue in the November elections.  What policies should be implemented to insure the creation of jobs?

Most folks don’t understand how or why we got to the high rates of unemployment.  But, only with that understanding, an understanding of what happened in the competitive economic environment that has made the U.S. uncompetitive and rocketed its unemployment rate into the stratosphere, will Congress and our economic policy makers be able to choose the correct path.

The answer is simple: it is a matter of cost.  It just costs too much to produce most goods in the U.S.  And, while the Congress and the Administration regularly demonize those private sector companies that produce their goods in lower cost countries, it is clear that the government itself is a huge part of the problem.

Over the past 20 years, the federal budget has grown at a compounded annual rate of 5.6%; that number is 6.8% over the past 10 years.  But, disposable personal income grew at a much slower 4.8% annual rate over the 20 year period and an even slower 4.5% annual rate over the last 10 years.  The implications of this data are that 1) taxes and fees have increased the costs of private sector businesses; 2) the ever growing government, by its nature, expands its span of control over the lives of its citizens through a rapidly expanding set of rules and regulations, all of which raise the cost of production.

Over the last two decades, the growing uncompetitiveness of  U.S. private sector business was obvious, as production facilities moved south of the border or overseas, and the lower cost countries like China, So. Korea, Mexico, Thailand, etc., began to emerge as economic centers.  While this was obvious, the ultimate impact on the U.S economy was masked by two bubbles, first the dot.com bubble, followed immediately by the housing bubble.  Both of these bubbles were enabled by excessively easy monetary policies.  And during this period, fiscal policy steadily marched toward structural deficits.  With the false sense of prosperity caused by these bubbles, there was no sense of urgency to reverse the trends.

Nevertheless, the bursting of the bubbles has unmasked two significant economic issues:  1) Overtaxation – the U.S. has one of the highest corporate tax rates in the world, and is one of a handful of countries that taxes its citizens on their worldwide incomes instead of the income made within the country.  In addition, the U.S. has relatively high income taxation coupled with state and local income, property, and sales taxes, various business fees, and a 15% payroll tax burden (not to mention the cost of other benefits paid for by many businesses). Business owners, looking for high returns on investments, move production to lower cost areas to avoid many of these onerous costs; 2) Over regulation – every Congress produces ever increasing regulations; state and local governments are no better.  And no regulations, no matter how worthless, ever go away.  For example, it costs the private financial sector significantly more to administer “backup withholding” (i.e., W-9s) than the cash generated for the government.

In addition, today we appear to have rogue government agencies that make their own laws (for example, the EPA does not appear to consider the cost/benefit in its rulemaking), compete in the private sector (the FDIC is now encouraging foreclosures on viable projects in order to maximize the return to itself – see Moral Hazard at the FDIC, TheStreet.com, August 4, 2010 and Reform is Needed at the FDIC, TheStreet.com, September 22, 2010), and transfer/redistribute private sector resources with strings attached, less the inefficient costs associate with bureaucracy (for example, The Department of Education has overseen the deterioration of American education with the imposition of non-productive and often nonsensical requirements on monies granted).

Besides the agencies, each Administration makes its own “law” through “Executive Orders”, sometimes just to satisfy a lobby.  For example, the ban on the reprocessing of nuclear waste by President Carter helped throttle the U.S.’s nuclear power program, and has contributed to its foreign energy dependence.  The most recent example of this is President Obama’s order closing deep water drilling in the Gulf of Mexico, an order that could cause much more economic damage than the BP oil spill itself.

The combination of the false prosperity caused by the bubbles, and the deterioration of the education system, has left the job market in disequilibrium.  By that I mean, there appears to be many available high paying jobs that go unfilled because there are not enough skilled or educated people in the ranks of the unemployed.  In fact, the unemployment rate among college graduates is 4.5%, less than half the 9.6% national rate.

What I have been discussing are long term issues, ones that will take years to resolve if, and only if, the high cost and the education issues are resolved.  Unfortunately, the U.S. is a country that demands immediate satisfaction.  So, the desire to fix the issue as rapidly as possible has led policy makers to opt for a weak dollar policy, i.e., a fall in the value of the dollar relative to the currencies of the major trading partners.  If this were possible, it would result in a reduction in the cost of production in the U.S. relative to the rest of the world because a unit of a foreign currency could now buy a greater quantity of American made goods. (What is ironic is that Congress raises the minimum wage, then, via a weak currency policy, effectively offsets the increase!)  But, despite the nice theoretical framework that a weaker dollar will increase exports and thus domestic employment, this won’t work in a dynamic system.  That is, the result of a weakening dollar is dependent on the reaction of the trading partners.  If the U.S. were some insignificant economy in the world, like, say, Grenada, no one would react if it weakened its currency.  But, the U.S. isn’t, and its trading partners are not going to let jobs in their economies migrate to the U.S.  So, their reaction to a weakening dollar is to weaken their own currencies to keep their relative cost advantage – and, thus, we have what appears to be “a race to the bottom” in the currency arena (and thus a spike in the price of Gold).  The reluctance of the Chinese to revalue the RMB (currently pegged to the dollar) is a good example.  A revalued RMB means less exports and more imports for China’s economy, thus stimulating jobs for those exporting to China and hurting China’s industries that produce for exports.  Because the trading partners will react, any attempt to weaken the dollar to gain exports is a zero sum game.  It leads to protectionism (e.g., recent U.S. tariffs on Chinese tires have recently been countered by increased duties on U.S. chicken exports to China), not to increased economic activity and more jobs.

The only way to increase manufacturing jobs is to increase production efficiency, either through lower costs, natural advantages (i.e., cheap natural resources), or a technological break through (which only lasts for a short period until the technology is disseminated to the rest of the world).  If costs are lowered sufficiently, manufacturing companies will choose to locate their production facilities in the U.S., thus creating jobs here.  No other policy trick will ultimately work.

In the end, the road to economic health and job creation is a long one that requires patience and political will.  For policy makers, this means lowering the costs of production in the U.S. via lower taxes, less regulation, a policy aimed at low cost energy, and a reformation in the delivery of education.  By their actions, I don’t think the policy makers in D.C. get this, so we are likely to have another round of the same old policies that simply don’t work.

Robert Barone, Pd.D.

October 5, 2010

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

September 23, 2010

The FDIC Nightmare

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 7:46 PM by Robert Barone

Wal-Mart is often criticized because when they put up their store in a small community, they drive out small businesses and mom and pop stores which cannot compete on price.  Nevertheless, Wal-Mart still pays taxes and has a cost of capital, so they cannot go everywhere.  Imagine if a Wal-Mart like competitor to small business existed that had virtually unlimited resources, paid no taxes, and had a 0% cost of capital.  No small business could survive if such an entity targeted a particular business or set of businesses.  Enter, the FDIC!

For over a year I have written blogs criticizing the FDIC’s approach to America’s Community Banks and what I have termed the “Unholy Washington-Wall Street Alliance” (see, for example, Health Care Bureaucracy May Be Like FDIC, March 30, 2010, www.ancorawest.wordpress.com/2010/03/ and Where is the Outrage II, August 11, 2009, www.ancorawest.wordpress.com/2009/08/ ).  In one blog, I observed that if she wasn’t careful and continued such policies, when the history of this depression is finally written and analyzed, Shelia Bair would be portrayed as a government bureaucrat whose policies and practices deepened the depression.   My colleague and I recently wrote a blog entitled Moral Hazard at the FDIC (TheStreet.com, August 4, 2010) in which we observed that, in the case of the disposition of the failed Corus Bank assets, among others, the FDIC had now become a private sector competitor, had chosen Wall Street partners and provided subsidies to them, and had assumed the role of entrepreneur and risk taker.  We observed through our models that, in the FDIC’s resolution of the Corus Bank assets, only under a significant rise in real estate prices was the recapture of FDIC insurance funds greater than if they just held the assets or sold them at current values.

In a September 8, 2010 Los Angeles Times piece (Downtown L.A. Condo Developer Takes on Investors, FDIC by Roger Vincent) we now learn that the FDIC and the Starwood investor group are fighting with Hassan “Sonny” Astani, a real estate condominium developer in Los Angeles.  In an interview, Mr. Astani stated:  “I face an unholy alliance between government and Wall Street”.

Corus Bank was Mr. Astani’s lender on his condo project in downtown L.A.  When Corus failed, the FDIC stopped funding his project which was 95% complete.  So, Astani auctioned off 77 units he had completed to garner enough cash to finish his 30 story project near the Staples Center.  But, Starwood and the FDIC objected.  According to L.A. City Councilwoman, Jan Perry, this is “a showdown between a local developer trying to finish a big project and high rollers with federal backing determined to grab his $260 million project at a discount”.

Consider the following facts in light of what might be the appropriate behavior of a federal agency:

  • The FDIC, with virtually unlimited Treasury backing, makes a deal with a Wall Street partnership in which the partnership receives a 0% loan and a 1% management fee;
  • The best outcome for the newly formed partnership (FDIC owns a 60% interest) is to hold all of the assets until the real estate markets recover;
  • Because it has a 0% loan, the partnership entity does not want any of the assets to be sold at current prices, so it fights with a developer who appears to be able to save his project from foreclosure.  That is, the partnership entity, because it has no interest carrying costs and gets a 1% management fee, desires to take this property in foreclosure, betting it will be worth much more in the future, and having all the time in the world to wait.

It is quite clear that the FDIC has become a player in the private sector with profit interests competing with, and diametrically opposed to, those of private citizens.  And, with unlimited funding, no taxes to be paid, a 0% cost of capital, and apparently, not answerable to anyone, how can the private citizen compete?

FDIC spokesman Andrew Grey said of this situation: “What we’re trying to avoid is creating the kind of financial incentives that cause the rapid liquidation of the portfolio at fire-sale prices, which could further depress already distressed markets.  The structured transaction enables the FDIC’s managing partner to take a longer-term approach to the loans, allowing for an orderly workout period”.

It’s time for America to wake up to what the FDIC is doing!  Small banks received very little TARP funds, mainly because most of them were filtered through the FDIC which refused, in many cases, to forward small bank TARP applications to the Treasury.  Now, partnering with Wall Street, the FDIC not only unnecessarily discounts the assets they commandeer, but they now  find themselves competing in the private sector and justifying their actions by indicating that their Wall Street partners need “time” for the real estate markets to heal.  Why don’t they give that precious “time” to the five banks they close every week?  As long as they are giving out “time”, such a process would surely result in a better outcome for the FDIC insurance fund since they wouldn’t have to unnecessarily discount assets to attract Wall Street partners.

With unlimited funds, the ability to discount assets to any level they desire, and the capacity to make 0% loans to their Wall Street partners, the FDIC has become an unfair competitor, motivated by greed (the desire for a maximum profit) to the detriment of the private sector and private citizens like Mr. Astani.

Wake up America!  Reform is much needed at the FDIC!

Robert Barone, Ph.D.

September 21, 2010

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

September 14, 2010

The Bond Bubble

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 4:35 PM by Robert Barone

The financial press has given credence to those who insist that, because interest rates have fallen rapidly since April, we are in some kind of a bond bubble.  Investors, they say, should shy away from fixed income because, surely, they will be hurt when interest rates rise.  Technically, this statement is correct – the crucial part of the statement is “when interest rates rise”.  If they rise in the near term, then the advice is accurate.  But if they aren’t going to rise for a long time, investors are missing out on valuable and stable returns.  To ascertain the time horizon, consider the following facts:

  • U.S. economic growth has recently turned anemic – from 5.0% in the 4th quarter of ’09, to 3.7% in this year’s 1st quarter, to 1.6% in the 2nd quarter.  Even with the most massive fiscal and monetary stimulus in history, growth appears to be decelerating.  GDP is still lower than it was at the 4th quarter ’07 peak (33 months ago).  This has never happened in post-WWII history.  Interest rates cannot rise under these conditions;
  • With unemployment at 9.6% and at 16.7% when underemployment is counted, and with the economy struggling to create jobs, where will the demand come from that causes businesses to demand funds to expand and cause banks to ration credit by raising rates?  In fact, bank loans have continued to contract since the economic malaise began, and businesses are sitting on the largest hoard of cash in history.  This environment isn’t conducive to rising rates;
  • The American consumer has 130% debt/income ratio, up from a 100% ratio in 2000.  History shows (Rinehart & Rogoff, This Time is Different, Eight Centuries of Financial Folly) that after credit bubbles burst, the consumer debt/income ratio reverts back to its pre-bubble level.  So, we still have a long long way to go.  I suspect that we will eventually get there through a combination of consumer debt repayment and default.   Once again, this is not an environment in which interest rates can rise;
  • Mortgage rates have fallen from over 5% to 4.3%, and still there is little demand.  There is a 12 month inventory of unsold homes at current sales rates, and this doesn’t count the shadow inventory not on the market or the continuing new supply surely to come from a continuing record level of foreclosures.  FNMA is once again offering loans with a $0 down payment!  If they can’t sell these homes with these rates and terms, how can they sell them if rates are rising?;
  • The Fed is talking about a second round of Quantitative Easing (governmentspeak for money printing). Increasing money supply implies a lower, not higher, level of interest rates.  The Fed has also told us that it isn’t going to raise rates for “an extended period”;
  • The “new normal” as PIMCO calls it, is a change in attitudes by the populous toward debt levels and a desire for higher savings and greater frugality.  Such attitude change also occurred in the Great Depression and had a lasting impact on the generation of that time.  Ditto here.  Higher savings increases the supply of lendable funds implying lower, not higher interest rates;
  • Baby boomers, approaching retirement age, have experienced two equity market meltdowns in the last 10 years.  They want more stability in their portfolios and perceive they can achieve that objective with fixed income instruments.  Their portfolios are currently under weighted in bonds.  So, the continuing demand for bonds appears to be strong.

There are two examples in modern history of very long periods of artificially low interest rates.  The first is 1942-1951 when the Fed “pegged” the long-term Treasury rate at 2.5%.  Today, the rate on the 30 year Treasury bond is 3.70%; so there may still be a significant downward move in rates, even from current levels.  The second example is the Japanese experience of the past two decades where interest rates have been similar to what we see today in the U.S.

While the supply of money appears plentiful, should we worry about the demand for our debt declining, thus causing rates to rise to place that debt?  The demand from the Chinese and the rest of the world, we are told by the bond bears, can dry up rapidly and cause our interest rates to rise.  Looking at the data, that has already begun to happen, as China reduced its holding of U.S. Treasury debt in both May and June, yet the 10 year Treasury yield peaked in April and has steadily declined.  With trillions of dollars in cash, no cost to borrow, no appetite for lending, no capital base required to hold Treasury debt, and the promise of low rates for an “extended period” by the Fed, U.S. banks are purchasing all of the debt the Treasury can issue.

Eventually, interest rates will rise.  The question is “when”.  Here are some indicators to watch:

  • Job creation of 200,000 per month and a falling unemployment rate;
  • GDP growth consistently above 3.5%;
  • The debt/income ratio of the American consumer approaching 100%;
  • An upsurge in home sales causing a rise in mortgage rates toward 5%;
  • The Fed eliminating “extended period” from its press releases and FOMC minutes.

None of these appear imminent.  If there is a bond bubble, it is in an early state, and, from the observations above, it appears that it will be quite a while before upward rate pressures appear.

Robert Barone, Ph.D.

September 8, 2010

The mention of securities or types of securities in this article should not be considered as an offer to sell or a solicitation to purchase any securities mentioned.  Please consult an Ancora West Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals.

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

September 7, 2010

Fighting the Economic Headwinds

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 6:04 PM by Robert Barone

I have written many blogs about the faltering U.S. economy and the continuing headwinds that will prevail for the next few years.  The headwinds include:

  • A consumer balance sheet loaded with debt with flat to falling income;
  • The  consumer’s major asset, the home, continues to fall in value with approximately 25% of homeowners with mortgages now underwater;
  • A banking system whose lenders to small business, community banks, are constrained by lack of capital and which are under attack by their government regulators insuring a continuing small business credit crunch;
  • The support of the “Too Big To Fail” with cheap capital injections, a bonanza in the arbitrage of borrowing at 0% and purchasing Treasury Notes at a 3.00 percentage point profit margin, while shrinking their lending each and every month.  Meanwhile, they’ve paid themselves outrageous bonuses while Main Street remains mired in Depression;
  • Federal Government economic policies which make the future so uncertain that businesses are reluctant to hire, including:
    • The adoption of healthcare reform against the will of the vast majority of the population with the unintended consequence of a significant increase in the cost of health care and, perhaps, a much poorer delivery system;
    • Interference in, and control of, private sector business including:
      • The government takeover of GM, forcing the firing of its CEO, and protecting 100% of Chrysler’s union pensions at the expense of the bondholders;
      • The passing of a financial reform bill that completely ignored the institutions (FNMA & FHLMC) and Congressional policies responsible for the sub-prime housing bubble, and the establishment of a new government bureaucracy which will, no doubt, make it much more difficult and costly for consumers and businesses to access credit;
      • The use by President Obama of Presidential fiat, against the advice of his own panel of experts, to stop all oil drilling in the Gulf of Mexico which, in my view, will have much more devastating and lasting economic impacts on the region than the oil spill itself;
    • The continuing threat to economic growth of cap-n-trade legislation which has the potential to significantly increase the price of energy.

Americans have now begun to realize that unemployment will be a significant issue for many years.  At the same time, they see that the folks in Washington either will not, or cannot, figure out how to really stimulate private sector job growth.  The U.S. economy cannot expand, and jobs will not be created until investors feel it is safe to invest and businesses feel confident they know the rules of the game and that those rules won’t soon change.

So let’s look at what policy changes are possible to eliminate the uncertainties and bring confidence back.  This will encourage business to take the risk of expansion and result in job creation.  There are 7 such policy changes listed below, 3 of which I will comment on extensively.  As each of these issues are addressed, if, indeed, there is the political will to do so, business confidence will improve and there will be a concomitant improvement in the equity markets:

  1. The Bush Tax Cuts:  It is not a well publicized fact that the net effect of the Bush tax cuts was actually an increase in the marginal tax rates for the wealthy from what they had paid previously.  Yes, the marginal tax rates in the table were reduced, but incomes expanded such that the “rich” (the top 1% of taxpayers) moved up to higher table brackets and actually ended up paying a higher proportion of their income in taxes than they had during the Clinton years (38% vs. 33%) (see Bill Frezza, http://www.realclearmarkets.com/articles/2010/08/16/the_hidden_truth_about_the_bush_tax_increases_98625.html).  The real issue, which has always been obscured by the way the arguments are presented, is not that there isn’t enough tax revenue, it is the explosion in government spending.  Since 1950, federal tax revenues have fluctuated between 16% and 19% of GDP.  And, during the Clinton years, we actually ran a substantial surplus.  Balancing of the federal budget is more about spending control than about lack of revenue.  It’s just easier for the Congress and the politicians to pretend it is a revenue issue and to obscure the real issue by concentrating on the tax issue.
  2. The Credit Crunch – Call off the Regulators: America’s small businesses are in the midst of a credit crunch.  The large, publicly traded corporations, have access to the national debt markets through Wall Street, and have recently taken advantage.  We’ve even seen 100 year bond issues.  Small businesses, on the other hand, don’t have such access and have traditionally relied on community banks and the shadow banking system (non-bank financial institutions) for their borrowing and working capital needs.  It is widely recognized that small businesses in the U.S. create the majority of jobs.  To break the credit crunch, small banks must be able to lend again, or at least be able to make credit available when businesses once again have enough confidence to expand. Under today’s conditions, even if small business wanted to expand, there is no credit available.  In July, Bloomberg News learned that in the case of the Corus Bank (FL) assets (and in 14 other similar cases), the FDIC gave Wall Street firms long-term 0% interest loans.  The FDIC indicated to Bloomberg that they did this to give those Wall Street firms “the time they needed for the Real Estate markets to heal”.  To relieve the credit crunch, why doesn’t the FDIC give the same consideration to small banks, i.e., give them 0% long-term loans to increase their capital, which will give them the same precious time for the Real Estate markets to heal as they are giving to the fat cat Wall Street firms?  A policy of TARP like injections into small banks which will give them both the capital and the time will go a long way to alleviate the credit crunch to small business, making economic expansion and job creation possible when businesses have gained back the confidence they need to expand.
  3. Fix the housing finance system:
  • The first issue is the number of underwater mortgages.  A reduction in the number of foreclosures is critical, yet every month we see these continue to expand.  Using tax policy, mortgage institutions must be encouraged to rework such loans both by lowering the interest rate and by extending the amortization period, even to 40 or 50 years, making these permanent if the homeowner remains current for a specified period.  While this won’t stop all foreclosures (e.g., households without employment), it may lessen them enough to restrict supply such that home prices eventually stop falling;
  • FNMA & FHLMC: These two, alone, have already cost the American taxpayer $150 billion, and the total bill is likely to be north of $500 billion (perhaps, even $1 trillion).  These two entities operated for many years with significant profitability until they were forced by the Congress to enter the sub-prime markets in the late 1990s.  Their original business model isn’t broken, it was changed by Congress.  A return to a public-private partnership with private capital, rational underwriting, a prohibition on lobbying and Congressional political appointments and interference, and run like a business with a board elected by shareholders would go a long way to restoring the housing industry to health;
  • As for the existing FNMA & FHLMC, shut them down and appoint a receiver to wind down their assets (maybe a 20 or 25 year endeavor).  Yes, this will be at great expense to the taxpayer.

Other actions that will have a positive impact on business confidence and on the equity markets (listed without further comments):

  1. Address the Social Security and Medicare unfunded liability issue;
  2. Develop a real energy policy that makes the U.S. energy independent in 15 years;
  3. Stop being the world’s policeman;
  4. Adopt a real immigration plan that stops illegals and encourages foreigners with the skills we need to be competitive in the world to immigrate here and become productive U.S. citizens (who will likely help create jobs).

Each of the above actions will restore some business confidence; several of the actions together will make a significant dent into the unemployment situation; any of these actions will garner a positive reaction from equity investors.

Robert Barone, Ph.D.

August 29, 2010

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

August 16, 2010

Warnings From the Past

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:42 PM by Robert Barone

On August 10, 2010, the Federal Reserve declared that it would prevent its multi-trillion dollar balance sheet from shrinking, in a continuing effort to spur the American economy.  The officials explained that they would take the proceeds from the maturing mortgage backed securities that they hold, and reinvest the proceeds into longer-term U.S. Treasury bonds.

It is important to understand that the monetization of debt, known as quantitative easing, is a subtle form of money printing.  The Fed assures us that it will “sterilize” the printed money in the future by selling securities back into the market, essentially soaking up cash.  They seem to be forgetting that many of the securities that they originally purchased at par are of dubious quality, and will command much lower prices when sold back into the market.  The price differential between the purchase and sale price of these bonds will eventually be the inflationary increase in the money supply.   As Government debt continues to build at unprecedented rates, the urge to print will more than likely become heightened.  The authorities will likely tell us that we have to print money and buy debt to keep rates low.  Our economy will not be able to handle high interest rates.   Can it handle large amounts of freshly printed money?

Most financial crises have been a function of debt accumulation that can’t be serviced by underlying cash flows.   Printing money has been promoted by academics and politician for centuries as a cure all for these crises.  If one reads history books, one quickly sees that money printing, in all of its various forms, has created more problems than it has solved.  It typically starts slowly, and increases as the desired results are never obtained.  As the printing continues, the value of the currency drops.  Nothing in this world escapes the law of supply and demand.  The larger the supply of money, the less the money is worth.  Purchasing power is reduced.   This loss of purchasing power is the root cause of inflation.  As inflation ramps up, the blame is laid on “greedy speculators” and “greedy businesses”.  The true cause of the inflation, money printing, is never mentioned.  The story is always the same.  Rather then add more to the discussion, I’ll let historical figures tell the tale.  I have taken it upon myself to highlight what we feel are the particularly important points in each piece.  Remember dear reader, you have been warned.

“Pamphlets continue to be issued, among them one so pungent that it is brought into the Assembly and read there.  The truth which it brings out with great clearness is that doubling the quantity of money or substitutes for money in a nation simply increases prices, disturbs values, alarms capital, diminishes legitimate enterprise, and so decreases the demand both for products and for labor; that the only persons to be helped by it are the rich who have large debts to pay. This pamphlet was signed “A Friend of the People.”   It was received with great applause by the thoughtful part of the Assembly.  Dupont, who had stood by Necker in the debate on the first issue of assignats, arises, avows the pamphlets to be his, and says sturdily that he has always voted against the emission of irredeemable paper and always will.” (Fiat Money Inflation In France, Andrew Dickson White, 1896, pg. 22)

“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency.  By a continuing process of inflation, governments can confiscate, secretly and unobserved, and important part of the wealth of their citizens.  By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.  The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become “profiteers,”, who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat.  As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth getting degenerates into a gamble and a lottery.

Lenin was certainly right.  There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” (The Economic Consequences of the Peace, John Maynard Keynes, 1920, pgs. 235-236)

And as the Federal Reserve uses proceeds from printed money to re-invest in ever growing quantities of Treasury Bonds, it is important to remember the words of the former Fed Chairman, Sir Alan Greenspan.

“The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods.” (Gold and Economic Freedom, Alan Greenspan, 1966)

We got into our current mess by getting into too much debt.  Instead of slowly paying our debt off and accepting reality, we going to try and print our way out of debt.  Current Fed Chairman Ben Bernanke, in his 2002 speech to the National Economist club, stated that Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” Money printing, historically, has never been effective in bailing out debt ridden countries.  The symptoms of heavy printing have been highly disruptive, and often cataclysmic to societies.  Still, we keep on trying, perpetuating the definition of insanity.  I’ll leave you all with a few more quotes that are appropriate to this discussion.

“History repeats itself, first as tragedy, second as farce. – Karl Marx

It is absolutely impossible to transcend the laws of nature. What can change in historically different circumstances is only the form in which these laws expose themselves.” -Karl Marx

The only thing we learn from history is that we learn nothing from history.” -Friedrich Hegel

The economy is currently slowing down, and widespread deflation may still set in.  Many people are purchasing risky, long term securities in order to provide income in today’s low return world.  Others are betting on reaping capital gains if long term rates decline.  Investors must remember that Bernanke appears to be committed to stopping deflation at all costs.  Also, confidence is a fickle creature.  When change comes to financial markets, it often comes swiftly and unannounced.  It may be wise to hedge deflationary bets with some kind of inflation hedge.

Matt Marcewicz

Ancora West Advisors

August, 10 2010

The mention of securities and investment strategies should not be considered an offer to sell or solicitation to purchase securities.  Consult your investment professional on how the purchase or sale of securities can be implemented to meet your particular investment goals.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

August 9, 2010

Moral Hazard at the FDIC

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 6:14 PM by Robert Barone

There has been a lot of discussion about Moral Hazard regarding the large bank bailouts (which the recent financial reform legislation apparently now has “institutionalized”).  And there has been a lot of commentary about the lack of help for America’s community institutions; in 2010 alone, the FDIC has closed 108 such banks (at least as of this writing).  It just appears to us that Washington protects the Wall Street firms to the detriment of Main Street.  We have written several blogs about this “unholy” alliance (http://www.thestreet.com/story/10771337/1/the-washington-wall-street-alliance).   Now, it appears that the FDIC, whose insurance fund was in the red by $21 billion at the end of the first quarter, has decided to become a player in the private sector by partnering with, you guessed it, Wall Street!.  This is a major strategic change in direction at the FDIC in how they deal with the disposal of troubled assets at failed institutions.  Specifically, the form of the strategic direction change is to allow a partnership with the private sector in order for the FDIC to participate in the upside potential of loan work outs and sales.  In technical lexicon, this is called an “Entity Sale” as opposed to a “Direct Sale” of the assets.

Partnering is not new to the FDIC, and it appears that the current strategic shift had its roots in the Resolution Trust Co. (RTC) model.  The RTC was the entity that dealt with the troubled assets from the S&L crisis era.  At that time, the FDIC, through the RTC, took back stock and warrants as part of their resolution in the largest failure cases of Continental Illinois and First City.  This created the public perception and significant outrage that “nationalization” was occurring; this seems eerily similar to today’s attitudes.

In one of their first forays into the entity sale strategy, the FDIC sold the assets of First National Bank of Nevada for between 30% and 50% of face value to Private National Mortgage Acceptance Company, LLC (PennyMac), a company founded by the former president of Countrywide.  The FDIC provided interest free loans to PennyMac, but kept an 80% equity stake, hoping to recover some of the losses should the real estate market turn upward.

Since the PennyMac deal, the FDIC has found it increasingly difficult to find private sector participants, so the last few deals have seen a reduction in FDIC’s equity stake to 60%.  For example, Colony Capital and the Cogsville  Group paid $445 million for a 40% stake in the assets of Community Bank of Nevada, First Bank of Beverly Hills, and New Frontier Bank.  The FDIC gave the group an interest free loan for slightly more than half of the purchase price, thus lowering the upfront cost to the group to $218 million in cash.

A July 21st news report at Bloomberg (FDIC Selling Corus Bank Loans is Bet on Failed Condos, Sterngold and Keehner) summarizes the policy shift.  “The new FDIC strategy for managing assets seized from failed banks has turned the agency into a long-term investor, making a multibillion-dollar bet on the recovery of some of the most distressed condominium markets in the country, from Miami to Las Vegas.  Instead of selling the assets to maximize cash in hand, the agency is offering its private-sector partners zero-percent financing, management fees and new loans to complete construction projects it can hold until markets recover.”  In the Corus Bank Deal, the partners, led by Starwood Capital Group, took a 40% stake in the new LLC entity while the FDIC retained 60%.  The partnership received an interest free loan for half of the purchase price.  It also received a promise by the FDIC to provide up to $1 billion in additional financing for working capital to complete the condo projects.  The private group also receives a management fee of 1% on the outstanding face value of the assets.  In order to put liquidity back into the deposit insurance fund, the FDIC sold $1.38 billion of notes backed by the partnership’s assets into the fixed income market with an FDIC guarantee.

We have several issues with this new FDIC approach:

  • First, a government agency has now become a private sector competitor with the ability to give zero interest rate loans to its partners, effectively giving these chosen ones a competitive market advantage.  These chosen few private sector partners can offer lower prices on their projects than the rest of the private sector.  Not only is this unfair, but it also puts more downward price pressure on the already strained real estate market.
  • Second, a government agency is now taking on the kind of risk normally associated with private sector capitalism.  Capitalists, of course, are looking for large returns.  At the same time, they are putting their capital at risk.  Risking capital just doesn’t seem appropriate for a government agency which is charged with protecting the public’s principal (i.e., FDIC insurance), not in risking it for outsized returns.
  • As a corollary to the above issue regarding risk, the FDIC is charged by law with resolving the problem assets in the “least cost” fashion.  Depending on what happens in the real estate markets in the future, the new approach may or may not be the “least cost” approach.

This last issue led us to examine the Corus deal more closely.  The Bloomberg article cited above provided details of the Corus Bank assets sold to the FDIC/Starwood public-private LLC.  We analyzed the possible outcomes and concluded that, only under very favorable market outcomes does the FDIC appear to come out better than if it just held on to the loans and sold them as the RTC did in the S&L crisis.

In the model discussed below, when we had to make choices about which assumptions to use, we always chose those that were favorable toward the FDIC. Here is the detail along with the assumptions:

  • The FDIC sold $4.5 billion of Corus Bank condo and other commercial real estate loan assets to the partnership for $2.77 billion, or about 61.5% of value.  The $4.5 billion of face value had already been written down by Corus to appraised value to somewhere south of $4.5 billion, but probably not to $2.77 billion.  We have no access to the written down values on the Corus books when the FDIC seized the assets.
  • Bloomberg indicates that because of the zero percent financing, the bid by the Starwood group was 20% higher, indicating that the “fair market” value was closer to $2.22 billion, or 49% of face value.  In the analysis below, we show the results for the “deal value” of $2.77 billion, as well as for the “fair market” value of $2.22 billion.
  • The FDIC advanced a $1.385 billion zero percent loan (50% Loan to Value ratio).  Then, in order to re-liquefy its balance sheet, on March 8th, it sold a note into the fixed income market for a similar sum ($1.377 billion).  That note was backed by the Corus assets and carried an FDIC guarantee.  Because this note was privately placed, there is no information available on the collateral (transparency?).  However, we have found the private placement announcements:
    • $150 million 0% coupon due October, 2011 at a discount of approximately 50 basis points (.50%);
    • $850 million 0% coupon due October, 2012 at a discount of approximately 110 basis points (1.10%);
    • $377 million 0% coupon due October 2013 at a discount of approximately 165 basis points (1.65%).

We assume that the interest rate on the note will average 2.5% if the assets are disposed of in 5 years rising to 3.5% if the term is 10 years.  This seems reasonable given the current yield curve.

  • The additional $1 billion in working capital financing to complete the condo projects is not analyzed in this model.
  • Normally, one would expect the collateral to have some cash throw off from monthly payments.  However, the assets all appear to be severely distressed, either in an unfinished stage (thus the need for additional working capital), or, if finished, with little or even negative cash flow.  As a result, we did not include any cash income to the partnership from monthly payments by the borrowers.
  • A Starwood private partner entity receives a 1% management fee based on the face value of the $4.5 billion of assets.  If nothing is sold, that amounts to $45 million per year.  The fee is paid, not to the public-private partnership, but to a separate “management” company owned by the private partners.  This is the typical hedge fund model.
  • The model assumes that the sales take place evenly over the time period assigned (e.g., 10 years).  In addition, the FDIC’s interest costs and the management fee costs are evenly amortized in the same way.  This assumption, in particular, works to the benefit of the FDIC.
  • The private sector Starwood partners’ investment is 40% of the required equity, i.e. $2.77 billion of assets less $1.385 billion of loan times 40%, or $554 million.

The tables below show the percentage of recoupment relative to the deal value ($2.77 billion) (i.e., FDIC Net/Deal Value) or the fair market value ($2.22 billion)(i.e., FDIC Net/Fair Market Value) that inures to the benefit of the FDIC over 5 and 10 year periods at various revenue realization levels relative to the deal value.  The appendix to this piece shows a complete model iteration using a 7 year time frame.

Sale Time Frame: 5 Years;   Equity: 60% FDIC, 40% Private

Sales Revenue/Deal Price 70% 100% 120% 150%
Private Partner Net Income (bill $) -0.251 0.081 0.303 0.635
FDIC Net Income (bill $) 1.533 2.031 2.364 2.862
FDIC Net/Deal Value 55% 73% 85% 103%
FDIC Net/Fair Market Value 69% 92% 107% 129%

Sale Time Frame: 10 Years;   Equity: 60% FDIC, 40% Private

Sales Revenue/Deal Price 70% 100% 120% 150%
Private Partner Net Income (bill $) -0.184 0.149 0.370 0.703
FDIC Net Income (bill $) 1.302 1.801 2.133 2.632
FDIC Net/Deal Value 47% 65% 77% 95%
FDIC Net/Fair Market Value 59% 81% 96% 119%

Observations:

  • The zero percent loan and the 1% management fee are perverse incentives from an FDIC point of view.  That is, the shorter the time frame to sell the assets at a particular price, the better off the FDIC.  But the zero percent loan and management fee make it to the advantage of the private partners to hold for longer periods of time.  The tables show that the private sector partners don’t make any money selling at fire sale liquidation prices, so it is in their best interests to wait for the real estate markets to firm up. (In the model, the private partners break-even at sale prices of about 90% of deal value.)  So far, the FDIC has done 14 such deals and is likely to do many more.  The overhang of the resulting assets, especially if banks continue to fail at their current rate, will continue to put downward pressure on real estate prices and makes even a 10 year time frame appear optimistic.
  • For the FDIC to receive the “deal price” ($2.77 billion) on a net basis, the assets would have to sell for nearly 150% of deal value ($4.16 billion) in 5 years and 160% ($4.43 billion) in 10 years.  On the other hand, if the FDIC kept the assets in an RTC type entity, it would only need to sell the assets at 100% of deal value ($2.77 billion)(plus costs).  This leads us to question whether or not this model is “least cost” to the taxpayers.
  • Said in another way, if the market does not “come back” in 5 years, but remains where it is, and the private partners decide to exit and sell for 100% of today’s deal value, the FDIC will get only 73% of deal value.  If this happens in 10 year, the FDIC gets only 65%.
  • As expected, if the ownership percentages are altered to 80% FDIC, 20% private partners, as in the PennyMac deal, the FDIC benefits at every sale price level to the detriment of the private partners.

Conclusions:

  1. Only if the real estate market recovers significantly (rising at least 50%) in the next five to ten years will the FDIC be “better off”.  It could be significantly “worse off” if the real estate recovery is modest or non-existent over that time frame.
  2. In this new “strategy”, we once again observe an “unholy” Washington-Wall Street alliance.  Large Wall Street institutions are given sweetheart deals and, as a result of such subsidy, have a significant competitive advantage over regular Main Street businesses.   If the FDIC is now giving out zero rate loans to the Wall Street entities so that they can “wait” for the markets to turn up, why don’t they just give that same zero percent financing to the institutions that they are about to seize, allowing them to count it as capital and giving them that same precious “wait” time for the real estate markets to recover? (Note: If they do this with the small banks, they don’t even need the cash – just accounting entries!)
  3. Finally, given the fact that the FDIC appears unable to structure a deal without a perverse incentive, we ask, do we really want the government in the risk/return business where poor decision making leads to loss of capital?

Robert Barone, Ph.D.

Joshua Barone

August 4, 2010

Appendix:  The Model

Sale Time Frame: 7 Years

Deal Value: $2.77 billion

Average Interest Cost to FDIC for Private Placement: 3.00%

Private Partner Ownership Percentage: 40%

Cash Invested by Private Partners: $554 million

In Bills $ except Percentages

Revenue/Deal Price 70% 90% 100% 120% 150% 160%
Revenue 1.939 2.493 2.770 3.324 4.155 4.432
Less: Loan Repayment -1.385 -1.385 -1.385 -1.385 -1.385 -1.385
Less: Management Fee -0.180 -0.180 -0.180 -0.180 -0.180 -0.180
Equals: Income to Split 40/60 0.374 0.928 1.205 1.759 2.590 2.867
Private Partner Split (40%) 0.150 0.371 0.482 0.704 1.036 1.147
Less: Private Cash Investment -0.554 -0.554 -0.554 -0.554 -0.554 -0.554
Plus: Management Fee 0.180 0.180 0.180 0.180 0.180 0.180
Equals: Net to Private Partners -0.224 -0.003 0.108 0.330 0.662 0.773
FDIC Split (60%) 0.224 0.557 0.723 1.055 1.554 1.720
Plus: Loan Repayment 1.385 1.385 1.385 1.385 1.385 1.385
Less: Interest on Note Issued -0.166 -0.166 -0.166 -0.166 -0.166 -0.166
Equals: Net to FDIC 1.443 1.776 1.942 2.274 2.773 2.939
FDIC Net/Deal Value 52% 64% 70% 82% 100% 106%
FDIC Net/Fair Market Value 65% 80% 88% 103% 125% 133%
Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

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