June 24, 2010

Indignant About BP? What About Fannie & Freddie?

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 7:15 PM by Robert Barone

On June 17, British Petroleum Chief Executive Tony Hayward was grilled on his company’s role in the ongoing oil spill disaster in the Gulf of Mexico.  Those hearings dominated business TV all day.  Some lawmakers asked insightful and excellent questions, while some resigned themselves to emotional populist rants.

At one point in the discussion, U.S. House Energy and Commerce Committee Chairman Henry Waxman (D, Calif.) told Mr. Hayward “There is not a single email or document that shows you paid even the slightest attention to the dangers at this well”.   At this time, from what we know, BP is at fault for this massive tragedy, and they have publicly taken responsibility and promised to pay for the clean-up and all economic and environmental consequences.  On June 16, the day before the aforementioned hearings, BP did pledge a $20 billion escrow account to begin to ease the economic consequences of the disaster.

While the oil spill is a huge economic and environmental disaster, we would like to know the following: Having cost the U.S. taxpayer $145 billion, and still “leaking” at $20 billion per quarter, why aren’t Congressional leaders “doing something” about Fannie Mae and Freddie Mac?  After all, they are the only body that can.  We note that the 2000+ page Financial Reform bill in Congress’ Conference Committee has not a single word devoted to the reform of these hemorrhaging mortgage giants.  Aren’t U.S. lawmakers just as irresponsible for this economic calamity as, it appears, BP’s management is for the oil disaster?  The U.S. is currently suffering from the largest credit bubble in its history.  More Americans have lost their jobs and their homes than at any time since the Great Depression.   One of the major reasons for this mess is Fannie Mae and Freddie Mac.

As far back as 2001, the Economist was calling Fannie a “big scary monster”.  The Wall Street Journal (WSJ), and its sister publication Barron’s, have dozens of articles going back to the late  1990’s discussing the risks of a housing and general economic meltdown related to the risks of Fannie’s and Freddie’s growing market share.  One of our favorite articles in the WSJ (2002) compared Fannie Mae to Enron, due to “ambitious” accounting which helped executives “earn” outrageous bonuses.  In addition, tens of millions of dollars were disbursed as political patronage via despicable director fees for Fannie and Freddie board positions.  Where was the “Pay Czar” then?  Why aren’t those directors being held accountable?

In summation, we believe that BP is a crisis that will define how the world extracts oil over the coming decades.  We agree that many people will be harmed, and that restitution should be paid.  We do have a problem with lawmakers pointing fingers while oil still leaks and before the reasons for the tragedy are known.   The “leaks” at Fannie and Freddie, in our view, will ultimately cost significantly more to the U.S. economy and taxpayers than will the BP disaster.   These same lawmakers should admit to a decade of playing down those economic risks.  They should be grilled on TV and asked why they didn’t do anything for an entire decade while being warned of potential economic collapse. If BP CEO Hayward needs to go, then why not Barney Frank?  He constantly downplayed the risks at Fannie and Freddie, and even encouraged more risks.  Should these leaders be allowed to fiddle while Rome burns?  Here are a few quotes, taken from a WSJ article titled “What They Said About Fan and Fred”, printed on Oct 2, 2008:

House Financial Services Committee hearing, Sept. 10, 2003:

Rep. Barney Frank (D., Mass.): I worry, frankly, that there’s a tension here. The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios. . . .

House Financial Services Committee hearing, Sept. 25, 2003:

Rep. Frank: I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing.

Rep. Frank: I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists.

Having been apprised many times about the dangers at Fannie and Freddie, the American public should be as indignant toward Congress about the “massive leaking” of taxpayer dollars, the devastation to the economy, jobs and income and the resulting human suffering as Congress is about BP’s irresponsible behavior.

Robert N. Barone, Ph.D.

Matt Marcewicz

June 18, 2010

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June 22, 2010

Robust Growth? Don’t Count on the Consumer

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 4:54 PM by Robert Barone

I recently attended a conference at which the speaker indicated that, since roughly 70% of GDP is consumption, the stimulation of consumption is necessary for full economic recovery and the resumption of robust growth.  The logic was as follows:  Rising consumption means more goods and services are consumed making it necessary for businesses to produce more.  This implies the need for more labor, and therefore an expansion in the number of jobs.  More jobs means higher incomes which means more consumption etc.  In all of the post-WWII recessions, this logic worked as those recessions were basically inventory corrections or caused by one off events.  The current economic malaise, however, is more like the Great Depression than any of the post-WWII recessions.  Like the Depression, this one was caused by bursting asset bubbles, high debt levels, and stagnant incomes, not only in the U.S., but in most industrial economies.  Thus, this is not a typical inventory correction cycle.  The model described above generated the idea expressed around the TARP legislation that we had to save the mega-banks because “credit is the lifeblood of the economy”.  As those banks have shown us over the past year and a half, loans outstanding have fallen every month.  And clearly as the consumer mortgage and credit card write-offs have shown, many U.S. consumers are not all that credit worthy.

The table below is a hypothetical comparison of two California families, each with one breadwinner making a $100,000 annual income, and 2 children.  Family A purchased a home for $250,000 and has a $200,000 5% 30 year fixed loan.  They have one car that is financed and no credit card debt.  Family B got caught up in the housing bubble and purchased a home in ’05 for $410,000, has a $400,000 5/1 ARM with a 5% teaser rate that resets to 4% on 7/1/10 and is fully amortizing over the remaining 25 years at reset.  Every 6 months it is subject to a new reset based on its underlying index.  The home’s value is less than the mortgage, so refinancing is not an option.  This family has 2 cars fully financed and credit card debt of $20,000 which was from cost to landscape and a vacation to an exotic destination.  The prospects for wage increases for both families over the next few years are almost nil with prospects of wage and benefit cuts looming.

Neither family is well off, but if Family A consumes its remaining income ($797/week – see table) in exactly the same way as Family B ($558/week), it can at least save $12,428/year for retirement.  In my first scenario, a very likely one, the Bush tax cuts are allowed to expire and California taxes rise 10%.

Scenario 1: Expiration of Bush tax cuts and CA income taxes rise 10%

• Family A:
  • Federal taxes rise from $12,138 to $14,633
  • California taxes rise from $4,539 to $4,993
  • Weekly remaining income falls from $797 to $740, a 7.2% decrease
  • Family B:
    • Federal taxes rise from $9,638 to $11,833
    • California taxes rise from $3,584 to $3,942
    • Weekly remaining income falls from $558 to $509, an 8.8% decrease
    • But Family B also has a change in their mortgage payment which, despite the rate reduction, rises from $27,060 to $32,380 per year (due to the amortization requirement), which now reduces remaining weekly income to $376, a 32.6% decline (Family B’s federal and state taxes actually rise because the interest deduction falls with the lower rate.)

Under this likely scenario, it appears that consumption will be hard pressed to rise for either Family A or Family B.  And while Family A can actually consume at the same level as before, they would have to do so by saving less.  That is, to continue to spend at $558/week, savings would have to fall $2,949 to $9,479 from $12,428.  Standard Economics 101 teaches that private sector savings and investment or even consumption is much more efficient (higher multiplier) than when government taxes and spends.  Meanwhile, Family B’s remaining income has taken a huge hit and it is likely that B will have to significantly reduce its consumption levels or take other drastic measures.

A second scenario, one that is less likely in the near term, but may occur if the world begins to lose confidence in the dollar, is that interest rates rise.  Scenario 2 is the same as Scenario 1 except B’s mortgage interest rises to 7% and its credit card interest rate goes up to 20%.  Note that these rates are not considered excessively high and were around as late as ’07.

Scenario 2:  Moderate increase in interest rates

• Family A: No change from Scenario 1
• Family B:
  • Credit Card interest rises from $3,000/year to $4,000/year
  • Mortgage PITI rises from $32,380 to $40,969
  • After consideration of a lower tax burden of $2,070 due to a higher interest deduction, the net impact on B’s remaining income is a net decrease of $7,519 from its Scenario 1 level (includes both mortgage and credit card interest), or an additional $145/week to $231/week, a 58.6% decrease from current spending levels of $558/week.  Clearly, Family B can no longer live in its expensive home, drive two fully financed cars, and carry credit card debt.  Credit defaults may be the only path available.

While the majority of American families look more like Family A, there is a significant proportion that fall into the Family B category.  It is clear that it won’t take much to push Family B over the edge, and many Family B types may actually succumb in Scenario 1, the most likely scenario.  If Scenario 2 becomes reality, the plight of Family B type Americans will truly be pathetic.

Observations

• The tax increases that appear inevitable for 2011 are likely to decrease both consumption and savings.  If economists believe that consumption must rise for the economic malaise to pass, the current policy direction is improper given a debt burdened consumer.  Even Family A is significantly impacted in Scenario 1;
• It is clear from the hypothetical families that households with higher debt levels are hit harder by tax increases (their remaining weekly income falls faster) than those with lower debt levels;
• The many families with 5/1 ARMS or Alt-A loans which were originated in ’05 and ’06 face significant headwinds when their mortgages begin amortization;
• Economists have recently been reassured as total consumer debt as a percentage of total disposable income has fallen 10 percentage points from its peak (M. Whitehouse, Real Time Economics, 6/12/10).  But it is not because consumers are voluntarily paying down their debt.  Financial institution write-offs account for more than the amount of consumer debt reduction observed.  This implies that consumers do not have the wherewithal to reduce their debt levels, much less take on more by going on a spending (consumption) spree – not a good sign for the path of consumption and economic growth;
• To make matters worse, the issues of employee wages and benefits at all levels of government relative to the private sector is rapidly becoming a national issue.  So, there will be downward pressure on those wages, benefits, and pension pay outs over the next few years putting additional pressure on consumers’ ability to spend.

Conclusion

It is clear that the folks in Washington, D.C. do not understand the structural issues U.S. consumers face.  To the extent that “Cash for Clunkers” increased consumer indebtedness, it pulled demand forward from future quarters and further burdened America’s consumers with additional debt on which interest must be paid.  Continued deficit spending with planned business and consumer tax increases will hurt, not help, consumption.  And, eventually, as the world loses confidence in the dollar, Scenario 2 unfolds, a real disaster for certain segments of U.S. consumers.  While deficit spending increases GDP, it is only temporary.  And, like “Cash for Clunkers”, it eventually burdens the economy with ever higher interest payments.  More appropriate policies include lower taxes and a balanced budget.  This means significantly less government spending, i.e., smaller government.  Unfortunately, much of today’s deficit is structural and cannot be addressed without a massive restructuring of the federal government.  How likely is that?  Thus, in my view, sustainable robust economic growth is not likely in any reasonable forecasting time frame.

As a result of this macroeconomic outlook, investors should avoid industries dependent on big ticket consumer outlays.  Housing is the most obvious, but most of the consumer cyclical stocks will, in my view, have top line revenue challenges in the forecast horizon.  Investors should choose equities with a high “margin of safety”, i.e., high levels of free cash flow, low debt, high barriers to entry, no or low unfunded pension liabilities, and consistent and rising dividends.  Bonds should be short-term in nature and the issuer should have a fortress type balance sheet and enough liquidity to pay the issue chosen should the credit markets refreeze.  Sovereign bonds should avoid countries with high debt/GDP ratios, and investors should be cautious and circumspect in purchasing municipal bonds.  On the positive side, most of the “margin of safety” companies are in the consumer staples, energy (once the BP crisis passes), and pharmaceutical sectors.  Finally, in a faltering economy, the response from Washington, D.C. is likely to be more of the same, i.e., continued high deficits while looking for additional revenue sources (fees or taxes).  This may hasten Scenario 2 discussed above.  A precious metals hedge would serve investors well should such a scenario arrive sooner than expected.

Robert N. Barone, Ph.D.

June 17, 2010

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June 14, 2010

Waiting for inflation? It’s already here.

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 9:19 PM by Robert Barone

The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds. – John Maynard Keynes

Much of the western world is mired in debt.  American consumers are walking away from their suffocating mortgage payments in droves, and consumer credit outstanding has barely declined.  To make matters worse, the U.S. is suffering from the highest level of unemployment since the Great Depression.

Many economists, market gurus, and television talking heads are waiting for the moment for inflation to strike.  Here is the conventional wisdom: Hopelessly indebted, the country, aided and abetted by the Federal Reserve (the Fed), is expected to aggressively monetize (print money) its debt, wreaking havoc on the exchange rate.  Bond prices are anticipated to fall, while commodity prices and interest rates are expected to rise.  Under this scenario, inflation, as measured by CPI, is expected to climb faster than the “goldilocks” rate of 2% of the last few years (1% currently), and standards of living are expected suffer as general prices rise faster than incomes.

While we agree with the “inflation” thesis expressed in the preceding paragraph, we also see a world that is more nuanced than do most market commentators.  While the above mentioned scenario may play out over the next few years, we see inflation as a current reality, and with significant consequences.

The most common measure of inflation uses a price index, like the CPI.  Even the Fed has tunnel vision when it comes to inflation, looking at it only through the narrow prism of indexes that measure the nominal changes in final prices.  We, on the other hand, believe that the idea of inflation encompasses both the nominal prices of goods and services as well as the levels of consumer incomes.  So, in our view, stable prices, as measured by the various indexes, may actually represent inflation if incomes are falling.  Our view, then, looks at the level of “living standards” which encompasses both income and price levels.

According to the CPI, we have experienced low and stable inflation over the last few decades.  But, one only needs to look up the prices of cars, jeans, college tuition, healthcare, rent, and many other day to day items to realize that the average American’s expenditures have grown at a much higher rate than the reported inflation number (see shadowstats.com for an eye-opening education on “changes” (perhaps, manipulation) of this calculation).  At the same time, the average American’s pre-tax income has remained stagnant for the last decade.  Rising prices vs. stagnant incomes is, by our definition, inflation because the purchasing power of the average American has decreased over the last decade. While our definition may be relative, the result has the same deleterious impact on those it affects as does the tunnel vision definition of inflation.

When one thinks about inflation in terms of living standards, one realizes that inflation can occur in different ways and have different impacts on demographic or social segments.

• Currency Devaluation:  In a currency devaluation, the immediate impact is on the cost and prices of imported goods.  Eventually, the prices of domestic goods will rise as input sources, especially if they are foreign, drive up production costs.  In April, 1933, FDR called in all the gold coins then in circulation, prohibited U.S. citizens from owning gold (not repealed until 1972), and paid the official price of $20.67 per ounce for the coins.  Nine months later, FDR devalued the dollar by raising the dollar price of gold to $35/oz, a 69% devaluation in terms of gold.  In our current experience, since 2002, the trade weighted dollar index has fallen 30% from 111 to 78, clearly a slow devaluation process.  And while the dollar has recently shown strength on investor concerns over the value of the Euro, the long-term trend is clearly down.  In fact, the Obama Administration’s goal is a higher level of exports, something that they plan to accomplish with a weaker currency.  Unfortunately, in a world where demand is falling, every industrial country wishes to increase their domestic output (and therefore domestic jobs) via more exports, and we are witnessing a “race to the bottom” in terms of currency values.  This is evident in investor increase in demand for gold as a monetary substitute and its consequent increase in value in terms of fiat currencies.  We suspect that the Obama Administration’s frustration with the peg of the Chinese RMB to the dollar has to do with the fact that the dollar can’t be depreciated against it.

• Artificially Low Interest rates: In the U.S., we have a rapidly aging population.  Many of these “baby boomers” are at or near retirement age.  As they have aged, many have shifted a larger portion of their liquid assets into fixed income securities.  It is also true that many of the ultra-wealthy, having already made their fortunes, have a significant portion of their assets tied up in fixed income.  Comparing today’s yield curves with the yield curve of 2007 makes it is clear that fixed income investors are taking a haircut on yield.  Three years ago, a bond portfolio of similar duration would have earned an investor between 2 and 4.5 percentage points more in interest return.  On a million dollars, today’s fixed income investors are earning $20,000 to $45,000 less per year, pretax.  For many fixed income investors, this has meant a 40%-75% reduction in income, depending on the duration of the portfolio.  A similar reduction in income can be seen for corporate bonds.  This represents a significant fall in consumer income. With the price indexes continuing to rise (although slowly), living standards have been impacted, and, as a result, these segments have endured the equivalent of a virulent inflation.

• It is clear that the Shadow Bailout (artificially low interest rates) has helped the banks repair their toxic balance sheets.  It is also clear that the manipulation of interest rates through the Fed Funds rate, the provision of near zero rate loans by the Fed to the large banks, and the resulting near zero deposit rates to consumers has drastically lowered the incomes, and hence purchasing power, of a large portion of American savers.  These reduced rates have also lowered the returns of pensions and endowments, further exacerbating their funding gaps, and putting future payouts in serious jeopardy.  It is a tragedy that many hard working, trusting Americans will be forced to face a future with lower incomes and less purchasing power which will reduce consumption, the bedrock of American GDP.  Lower incomes for the wealthy will also leave less money for investment (as will high taxes, currency issues and regulation), helping to ensure slower economic growth.

• Rising Debt Loads: When interest on debt, especially public debt, grows faster than income, the required interest payments must eventually come from the dwindling income pool. If interest rates rise, the problem becomes more acute and more immediate.  This means higher tax rates, which reduce discretionary income and thus reduce living standards.

When viewed through a non-traditional lens, it is clear that slow devaluation, low interest rate policies, and endless debt have already created the equivalent of more traditionally defined inflation.  Bond prices are “inflated” in much the same way that real estate and housing were in the last two bubbles.  With heavy supplies looming large over the next few years, there must surely, eventually, be a mismatch between bond supply and investment demand, at least at today’s anemic yields.  Living standards, for many, have already been reduced.

While we agree that our massive debts will eventually be monetized, and that a general inflation will more than likely be part of our future, we believe that a type of inflation is already manifesting its ugly head.

What can an investor do? Stay out of debt, keep some dry powder, and stick to the highest quality assets.  Mind your margin of safety, and own a gold hedge if you can stomach the potential volatility.

Robert Barone, Ph.D.

Matt Marcewicz

June 9, 2010

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June 4, 2010

Will Build America Bonds save the States from default?

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 6:16 PM by Robert Barone

There has been a lot of talk recently about whether Build America Bonds (BABs) will be able save the state and local governments from possible default.   The BABs market recently broke a sales milestone of $100 billion, this done amazingly within in 13 months of the first bond issuance.

The Build America program was created in the American Recovery and Reinvestment Act of 2009.  Designed to spark investment in state and local government capital projects, the so called shovel ready projects, the program’s objective was to save or create 3.5 million jobs.  There are two types of BABs.  The first type, called Tax Credit bonds, are similar to traditional muni-bonds, in that the investor receives a 35% tax credit on the coupon payment.  The second type, called Direct Payment bonds, gives the issuing government a 35% rebate from the U.S. Treasury on the coupon interest.  To date, the vast majority of issuance has been in the Direct Payment arena.  It appears that the reason for the disproportionate issuance of the Direct Payment bonds has to do with the pool of potential buyers.    Because there is no preferred tax treatment for investors, interest rates are higher than those of traditional muni-bonds.  As a result, the pool of potential investors is increased as tax exempt or deferred accounts like pensions, retirement accounts, or foreign investors who wouldn’t reap the tax benefits of muni-bonds, are more likely to be purchasers.  Investors can now get a corporate bond type of return with a muni-bond type risk.    As a result, within the last year we have seen the launch of new EFT’s design to follow BABs.  Invesco’s PowerShares Build America Bond ETF (BAB) and Eaton Vance’s Build America Bond fund (EBABX) were created in November 2009, while the SPDR Nuveen Barclays Capital Build America Bond ETF (BABS) was recently created this May.   These funds will also push BABs out to smaller investors looking for diversification.

The Obama Administration is calling the program an enormous success, and included an extension to 2013 in the recently passed Jobs Bill this March.  While the program looks to be working, and bond issuers have saved roughly $12 billion in interest payments compared to what they would have paid in traditional muni-bonds, there has been growing opposition to the program.  Senator Chuck Grassley (R) calls the program a fleecing of the American taxpayer.  He purports that it merely robs from Main Street and rewards Wall Street in the form of high underwriting fees, and is advocating to have the program abolished.  With the Bank of America Build America Bond index returning 8.9% this year compared to a 2.75% index return in traditional municipal securities, it is no wonder that the market is growing so rapidly.  Is this a viable solution for the states and municipalities or, as Senator Grassley suggests, a fleecing of America?

The Wall St. fees are “surprisingly high” say Edward Prescott, a Nobel-prize winning economist.  Typical underwriting fees for BABs are $8.20 for every $1000 while traditional issues range between $5 and $6 per $1000.   “Of course state and local governments are big fans of Build America Bonds program—they get federal money that they don’t have to pay back,” Grassley said in a March 16 floor speech.  “And the large Wall Street investment banks love Build America Bonds—they’re getting richer off them,” as Goldman Sachs has received 10% of the total market issuance in the form of fees.  Grassley continues, “However, we all know there’s no such thing as a free lunch.  Federal taxpayers are footing the bill”.

The Congressional Budget Office estimated last year that BABs would cost the Treasury $4 Billion over 10 years, but, as usual with government projections of cost, the bonds have defied all expectations, and the program is now projected to add $30 billion to the deficit, a sevenfold increase.  With the program accelerating and the Obama Administration talking about make it permanent, although with a small caveat of reducing the subsidy to 28% to 30%, it appears that the taxpayer will be on the hook for an ever increasing amount.

Treasury Secretary Timothy Geithner said in January, that the bonds “were successful in helping to repair a severely damaged municipal finance market, making much needed credit available at lower borrowing costs for infrastructure projects that create jobs”.  He went on to say, “By making Build America Bonds a permanent and expanded financing tool for state and local governments, we’re investing in our country’s long term economic growth in a cost-effective way.”  The new proposal that the Administration has put forward expands the scope of the program to allow for the refinance of current debt, to cover short-term governmental operating costs, and to finance non-profit hospitals and universities.  This appears to include the financing of the huge level of unfunded state pension liabilities in many states like California and New Jersey.

On May 26, 2010 the State of Florida’s bond finance director, Ben Watkins, declared that the state will no longer participate in the issuance of Build America Bonds until such time that the government guarantees the subsidy on the program.  Watkins is worried that the Treasury can withhold all or part of the states subsidy, in Florida’s case some $600 million, if the issuer owes monies to the federal government through programs such as Medicaid, etc.   Florida is not the only state or municipality in this boat.  In February the IRS withheld subsidy payments to the City of Austin, Texas over payroll taxes, while the City of Los Angles was garnished some $28 million over an unspecified liability on $307.4 million of Airport bonds.  “It is a very real risk” that a subsidy payment may be garnished at some point over the life of the bonds, which is often about 30 years, Watkins said.

The BABs program is obviously accelerating, as leveraged states and municipalities look for ways to finance capital projects, budget shortfalls, and unfunded liabilities. It looks like BABs will help them temporarily extend durations and lower interest rates.  But will it save them?

In my view, while it helps in the short run, all BABs really do is delay the inevitable day of reckoning because it allows state and local governments to continue their spendthrift ways, burdening further the already over indebted American taxpayer (see Wow!! That’s A Lot of Debt! at TheStreet.com and www.ancorawest.wordpress.com).  Worse, BABs will make some state and local governments serfs of the federal authorities.  If they don’t tow the federal line for other federal programs like Medicare, Medicaid, the new health care law and other future and costly federal mandates, the Treasury can “garnish” the subsidies owed.  Given the deteriorated condition of state and local finances and the likelihood that such budgets will be squeezed for the indefinite future, the very independence of the states appear threatened.  Florida appears to have recognized this threat.

In the end, BABs 1) are too costly; once again, Wall Street appears to be benefitting, again at the expense of the American taxpayer; 2) make it too easy for state and local governments to continue their profligate ways which will continue to place heavier debt burdens on the taxpayers; and 3) threaten further to erode the constitutional concept that states are independent of the federal government.

Joshua Barone, Managing Partner

Robert Barone, Ph.D.

June 1, 2010

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June 2, 2010

The Symbiotic Washington-Wall Street Alliance

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 8:18 PM by Robert Barone

Despite all of the political rhetoric surrounding financial reform legislation, “Too Big To Fail”, over leverage in the banking system, and high risk bets at proprietary Wall Street trading desks will not be resolved in the pending legislation because Washington and Wall Street have a symbiotic relationship held together by the realization on both sides that they need each other for survival.

Recently, The Wall Street Journal (‘Banks Trim Debt, Obscure Risks’, Rapoport & McGinty, May 25, 2010) revealed that the large Wall Street banks manipulate (“window dress”) their end of quarter numbers to make it appear that they have significantly less leverage (and therefore more capital) than, in reality, they have.  In looking at 10 quarters of average data that the largest eight banks are required to disclose, the Journal found that, on average, borrowings were 41% higher than reported on their required quarterly “Call Report”.  Those reports only require a snapshot of the balance sheet on the call report date, i.e., the last business day of the quarter.  So, by significantly reducing “borrowings” on the last day of the quarter, they are able to hide their true leverage and technically produce higher capital ratios for their regulatory reports.

Such leverage, of course, was and continues to be the major cause of financial instability.  Leverage, along with the risks taken by the proprietary trading desks of the “Too Big To Fail” were supposed to be fixed by the financial regulation bill now in a House-Senate conference committee.  But, a closer look at the pending legislation reveals that neither excessive leverage nor the risks taken on the proprietary trading desks have really been addressed.  A Wall Street Journal opinion piece entitled ‘The New Lords of Finance’ (May 24, 2010), indicates that the Volcker Rule (restrictions on proprietary trading) “is really a Volcker Suggestion”, as the bill gives the appointed regulator the “authority to immediately rewrite the law”.  Imagine the lobbying and campaign contributions that are now about to take place!

Let’s not forget that the new financial regulations were also supposed to resolve the “Too Big To Fail” issue, itself.  But, according to the Journal, the pending legislation fails here too.

… the discretion handed to the FDIC as the resolution overseer allows a replay of the AIG debacle in which the company was used as a conduit to pay counterparties 100 cents on the dollar

Remember that the beneficiaries of the AIG payouts of 100 cents on the dollar for AIG highly impaired credit default swaps were Goldman Sachs, JPMorganChase, Citigroup etc.

The FDIC will now be empowered to do the exact same thing, except that it will be allowed to discriminate even further – with the discretion to give some creditors a total bailout while imposing losses on others.  Think United Auto Workers versus Chrysler bond holders.

Given the gravity of the financial meltdown and its implications for the well being of the economy, one has to ask why neither the leverage nor the proprietary trading (gambling) issues of the “Too Big To Fail” are being adequately addressed.  The fact is, there is a symbiotic relationship between the giant banks and Washington, D.C.  Worse, the recent actions of the European Central Bank (ECB) reveal that this problem is not endemic to the United States alone.

So, why the kid gloves?  As government expands and the politicians deficit spend furiously to try to turn the economy around in order to save their own jobs come next election, who buys all of this new debt?  There had been fears in the marketplace that the explosion of debt would find few buyers, fears that foreign central banks and the Chinese would shun Treasury Bills and Notes.  Who would buy this mountain of debt?  The answer: “Too Big To Fail” banks.  Perhaps this was the main reason they were given TARP!  And the slope of the yield curve is the icing on the cake.  That is, “Too Big To Fail” banks borrow from the central bank (the Fed or ECB) or the public at near 0% and buy sovereign debt at 300-400 basis point spreads.  Because of capital rules (both in the U.S. and Europe), no capital is required as reserves against potential default, because, after all, these are AAA rated sovereign government securities.

Or are they?  The fact that Fitch downgraded the debt of Spain (from AAA to AA+) on May 28, 2010 may yet be another canary in the coal mine.  The exploding Debt/GDP ratios in the U.S. and industrialized world (see Wow!! That’s a Lot of Debt! At TheStreet.Com or at https://ancorawest.wordpress.com/) indicates that there is real risk to holding large volumes of such sovereign debt despite AAA ratings to the contrary.  Unfortunately, the “Too Big To Fail” institutions, both here and abroad, hold significant levels of sovereign debt, much of which is now of increasingly questionable quality (see Europe Pulls a TARP at TheStreet.com).  Worse, there is no back up capital.

Not to worry!  Given the symbiotic relationship between the governments in the U.S. and Europe and their banking systems, we can count on further assistance from taxpayers should the need arise (and it appears that there is a good chance that it will).  “Too Big To Fail” institutions know that because their governments need them to buy their ever growing debt, they won’t have to give up their highly leveraged ways or their immensely profitable proprietary trading (gambling) habits.  All they have to do is play the debt purchase game.

Robert Barone, Ph.D.

June 1, 2010

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