July 27, 2012

New Soap Opera: The Comedy of Euros

Posted in Banking, Bankruptcy, Economy, Europe, Finance, greece, Spain tagged , , , , , , , , , , , at 8:49 PM by Robert Barone

The term “European Theater” was first coined during World War II. Today in the financial markets, the term has come to symbolize an ongoing soap opera, where the audience is continually held in suspense as the bad actors (the politicians) promise actions and solutions to current crises, which have been created by their prior actions. Each time solutions are proposed, the audience breathes a sigh of relief (i.e., relief rally in the equity markets) only to be disappointed when they find out that the solutions won’t work or can’t be implemented.
 
As a result, the crisis and suspense continues, keeping the audience’s total attention (even while dinner on the stove at home is burning). Meanwhile, a new issue or crisis appears, it seems, on a daily basis.
 

Likely New Episodes

Daily we watch yields on Spanish and Italian debt move ever higher, now in zones where other countries have cried “uncle” and asked for bailout help. At the same time, the credit default swaps on Spanish and Italian debt have risen to record levels.
 
New Episode: Will the capital markets force a Spanish bailout by locking Spain out of the debt markets?
 
  • Spanish bank recapitalization: We have recently learned that the European Central Bank is willing to impose losses on the shareholders and junior bondholders of some of the Spanish savings banks. (When they bailed out Ireland, all bondholders were saved.) The draft of the document meant to give Spain’s banks 100 billion euros has this provision, but the periphery’s finance ministers are opposing it.
 
  • New Episode: Is 100 billion euros enough for Spain’s banks? The general rule of thumb appears to be that the ultimate amount needed is usually higher by a factor of at least two.
 
  • Spain’s regional provinces are now coming hat in hand for bailouts of their own. And those regional governments must refinance more than 35 billion euros in the near future.
 
  • New Episode: Are there enough resources in the European Financial Stability Facility (EFSF), the temporary bailout fund, and the European Stability Mechanism (ESM), the proposed permanent bailout fund, to bail out Spain and its regions? What about Italy?
 
  • The problematic link between Spain’s sovereign and its bank’s balance sheets has not been severed, as the audience was led to believe during the “Summit” episode.
 
  • New Episode: Will the ESM require the Spanish government to guarantee the bank capital? If so, will market reaction drive borrowing rates for Spain even higher, or lock them out of the capital markets altogether?
 
  • Greece now appears unable to produce an austerity plan acceptable to the Troika (EU Commission, ECB and International Monetary Fund). Greece has a 3.8 billion euro bond payment due in August. And the ECB just announced that it will no longer accept Greek government bonds as collateral for loans, thus locking Greece out of ECB borrowing.
 
  • New Episode: Will the Troika impose its own plan, or will it withhold bailout funding? Without access to the ECB, will Greece default again? And, will this lead to Greece’s immediate and disorderly exit from the monetary union?
  • Each monetary union country is required to put capital into the ESM. Italy will be required to pony up 20% of the ESM capital.
 
  • New Episode: What sense does it make for Italy to borrow at 7% when the ESM would offer a rate of return that is closer to 3%?
 
  • The ECB holds tons of Greek debt on their balance sheet at par (i.e., 100% of face value) (Portuguese, Spanish and Italian debt, too). If (when) Greece leaves the monetary union, they will renounce this debt, causing the ECB to need more capital to cover this loss.
 
  • New Episode: Will the remaining members be able to contribute even more capital? That will put additional pressure on the weaklings — again, Portugal, Spain and Italy will have to go to the capital markets to borrow at extremely high rates to meet their capital contribution requirements.
 
  • Will the ESM be allowed to purchase sovereign debt in the secondary market as promised in the “Summit” episode? This is meant to support Spain and lower the interest rate it has to pay to borrow. The Dutch, Finns and probably the Germans may say ‘Nein.’

Politicians in a Box

The bad actors in this soap opera, the politicians, know that if they attempt to do the right thing, they will be voted out of office by populations who value their entitlements more than anything else. Look at Greece and the near victory by the Syriza party (anti-austerity) in the last set of elections. And now, we see riots in Spain.
 
These bad actors have proposed so-called “fixes” that merely kick the can down the road, from bailouts (Greece, Portugal, Spain, Ireland) to a banking union in order to avoid addressing the core issues. The fixes enacted calm the audience for shorter and shorter periods. For example, the deposit flight from Spain’s banks now continues unabated, despite the capital plan for Spanish banks announced during the recent “Summit”.
 
This soap opera will continue to play out because liquidity does not produce solvency. The ECB and politicians can throw all of the money they can create at the problem, but, until debt restructuring occurs (i.e., dealing with the debt), the soap opera will continue. Debt restructuring means that some lenders won’t get repaid at all and others will have to take a haircut. Inevitably, some financial institutions (i.e., lenders) will fail. The game to keep them alive cannot go on forever.
 
Eventually, the markets will tire of the soap opera, lose confidence (as they appear to be doing), and close the capital market to these players. It would be much better to have an orderly restructuring than a disorderly one imposed by a panicky market. But, so far, no European leader has stepped up with such a plan (i.e., a plan to exit the weaklings from the monetary union).
 
Without such a plan, the stronger European nations (like Germany, Finland and The Netherlands) will soon have had enough and will leave the monetary union on their own, most likely, to go back to their old currencies.
 

The Final Episode?

It appears that many of the New Episodes described above will soon play out as the situation appears to be in endgame mode. Some sort of resolution acceptable to the capital markets is being demanded by those very markets. The roller coaster is at full speed and it appears the tracks are about to end.
 
What new games can the European politicians play to buy more time? Is there anything they can do, short of having a plan to exit the southern weaklings that can now save the euro? What can they do now to even buy more time?
 
Unfortunately, it appears that a market-imposed resolution, which means market panic and financial chaos for Europe with grave worldwide implications, is rapidly approaching.
 
 
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

July 9, 2012

Economic issues, good and bad

Posted in Banking, Big Banks, debt, Economic Growth, Economy, Europe, Federal Reserve, Finance, government, greece, Housing Market, International Swaps and Derivatives, investment advisor, investment banking, investments, Italy, recession, sovereign debt, Spain, taxes, Unemployment tagged , , , , , , , , , , , , , , , , , , , , , , , , , at 3:17 PM by Robert Barone

This is a mid-year overview of the economic and policy issues in the U.S. and worldwide, both positive and negative. I have divided the issues into economic and policy issues. With enough political will, policy issues can be addressed in the short run, while economic issues are longer-term in nature and are clearly influenced by policy.

Positives

• Cheap energy (economics and policy): There is growing recognition that cheap energy is key to economic growth; the next boom will be based on cheap energy.
 
• Manufacturing (economics): After years of decline, American manufacturing is in a renaissance, led by the auto industry.

• Corporate health (economics): Large corporations are extremely healthy with large cash hoards and many have low cost and low levels of debt.

• Politics (policy): Americans are tired of special interests’ ability to pay for political favors.

 
Negatives
 
• Recession in Europe (economics): This has implications for world growth because Europe’s troubled banks are the engines of international lending; Europe’s economy rivals that of the U.S. in size.

• European Monetary Union (policy): A Greek exit from the euro is still probable after recent election and is likely to spread contagion to Portugal, Spain and even Italy. There is also danger here to America’s financial system.

• Brazil, Russia, India, China or the BRIC, Growth Rate (economics): China appears to be in danger of a hard landing, as is Brazil. India is already there. This has serious implications for commodity producers like Canada and Australia.

• Fiscal cliff and policy uncertainties (policy): A significant shock will occur to the U.S. economy if tax policy (Bush tax cut expiration and reinstatement of the 2 percent payroll tax) isn’t changed by Jan. 1, 2013.

• Entitlements (policy): Mediterranean Europe is being crushed under the burden of entitlements; the U.S. is not far behind. This is the most serious of the fiscal issues but the hardest for the political system to deal with.

• Housing (economic & policy): In the U.S., housing appears to have found a bottom, but because of falling prices and underwater homeowners, a significant recovery is still years away. Housing is a huge issue in Europe, especially Spain, and it will emerge as an issue in Australia and Canada if China has a hard landing.

• Energy costs (economics & policy): The current high cost of energy is killing worldwide growth (see “Positives” above).

• U.S. taxmageddon (policy): The U.S. tax system discourages savings and investment (needed for growth), encourages debt and favors specific groups.

• Too Big To Fail (TBTF) (policy): The U.S. financial system is dominated by TBTF institutions that use implicit government backing to take unwarranted risk; TBTF has now been institutionalized by the Dodd-Frank legislation; small institutions that lend to small businesses are overregulated and are disappearing.

• Debt overhang (economics): The federal government, some states and localities and many consumers have too much debt; the de-leveraging that must occur stunts economic growth.

• Inflation (economics & policy): Real inflation is much higher than officially reported. If a true inflation index were used, it is likely that the data would show that the recession still hasn’t ended.

It is clear from the points above and from the latest data reports that worldwide, most major economies are slowing. It is unusual to have them all slowing at the same time and thus, the odds of a worldwide recession are quite high.

In the context of such an event or events, the U.S. will likely fare better than most. But that doesn’t mean good times, just better than its peers. There is also greater potential of destabilizing events (oil and Iran, contagion from Europe, Middle East unrest), which may have negative economic impacts worldwide. Thus, in the short-term it appears that the U.S. economy will continue its lackluster performance with a significant probability of an official recession and vulnerable to shock type events. (Both the fixed income and the equity markets seem to be signaling this.)

 
 
The extension of Operation Twist by the Federal Reserve on June 20 (the Fed will swap $267 billion of short-term Treasury notes for long-term ones through Dec. 31 which holds long-term rates down) was expected, and continues the low interest rate policy that has been in place for the past four years. That means interest rates will continue to remain low for several more years no matter who is elected in November. Robust economic growth will only return when policies regarding the issues outlined in the table are addressed.

Looking back at my blogs over the years, I have always been early in identifying trends. The positive trends are compelling despite the fact that the country must deal with huge short-term issues that will, no doubt, cause economic dislocation.

The only question is when the positives will become dominant economic forces, and that is clearly dependent on when enabling policies are adopted. 1) In the political arena, there is a growing restlessness by America’s taxpayers over Too Big To Fail and political practices where money and lobbyists influence policy and law (e.g., the Taxmageddon code). 2) The large cap corporate sector is healthier now than at any time in modern history. Resources for economic growth and expansion are readily available. Only a catalyst is needed. 3) America is on the “comeback” trail in manufacturing. Over the last decade, Asia’s wages have caught up.

Cultural differences and expensive shipping costs are making it more profitable and more manageable to manufacture at home. 4) Finally, and most important of all, unlike the last 40 years, because of new technology, the U.S. has now identified an abundance of cheaply retrievable energy resources within its own borders. As a result, just a few policy changes could unleash a new era of robust economic growth in the U.S. Let’s hope those changes occur sooner rather than later!

 
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

The New Bank Paradigm: Squeezing Out the Private Sector

Posted in Banking, Big Banks, debt, Economic Growth, Economy, Europe, greece, Italy, Spain, Uncategorized tagged , , , , , , , , , , , , , , , , , at 3:08 PM by Robert Barone

Since the world adopted Basel I in 1988, it has allowed the Europeans to dictate the bank capital regime for major industrial economies. We are now in the process of adopting Basel III capital rules. Unfortunately, these rules have so biased the financial system that the private sector, the engine of job creation, has all but been squeezed out.Under all of the Basel regimes, “sovereign” debt is considered riskless. Everything else has a varying degree of risk to it which requires a capital reserve. Loans to the private sector have the highest capital requirements. Americans have always viewed our US Treasury debt as “riskless.” So, on the surface, it appears reasonable that no capital should be required, and Americans think no further. But, further thought would reveal two significant issues: 1) The “sovereign” debt of other countries may not be riskless (ask the private sector holders of Greek debt, or Jon Corzine and MF Global (MFGLQ) folks about the risks associated with Italian debt); 2) The bias imparted with this sort of capital regime makes loans to the private sector unattractive, especially in times of economic stress where bank capital is under pressure. But, it is in times of such stress that loans to the private sector are needed to create investment, capital spending, and jobs.

One of the reasons for all of the stress in Europe is the fact that their banking system holds huge amounts of periphery country debt (Greece, Spain, Portugal, Italy) with no capital backing. On a mark to market basis, most, if not all, of the capital of the periphery banks disappears. In fact, the European Central bank (ECB) itself is still carrying the Greek debt it holds on its books at par, as if there is no chance that they won’t be repaid in full.

Since the financial crisis of ’08-’09, Western banking systems have come to rely on government, at first as the capital provider of last resort, but now, at least in Greece and Spain, as the capital provider of first resort (most likely because there is no other). In a symbiotic relationship, those same governments have come to rely on the banks to purchase their excessive supply of debt. The capital rules favor this unhealthy relationship. In effect, we now have a banking DNA bias against private sector lending.

We have heard the politicians in Washington rail against the banks for not making loans to the private sector. Yet, all of the rules, regulations, and enforcement processes make it difficult, if not impossible, to do just that. The overbearing regulatory process strangles private sector lending at small community banks. And, as indicated above, the capital regime itself, which impacts all banks, discourages private sector loans. For example, a $1 million loan to the private sector requires $200,000 in capital backing plus an additional $20,000 to $30,000 in loss reserve contribution from the capital base. That same $1 million loan to the US Treasury, via purchases of Treasury securities, requires no capital or reserve contribution. The ultimate result is that, since the financial crisis when western governments found out that it was politically okay to “save” (i.e. recapitalize) large banks with public monies, they also found out that the capital and regulatory regime now made those same banks major buyers of excessive government debt.

Unfortunately, while governments like this and will continue to promote it because it keeps the cost of borrowing low and provides them with a ready market for deficit spending, government is not the economic engine. That is what the private sector is. Simply put, the banking model in the west now promotes moral hazard (banks making bets that are implicitly backed by taxpayers) and Too Big To Fail (TBTF) policies while it stifles private sector lending. The Dodd-Frank legislation has institutionalized this model with government intervention now seen as the first response to a banking issue. If it hasn’t, then why did President Obama say on The View the business day after JPMorgan Chase (JPM) announced its trading loss that it was a good thing that JPMorgan had a lot of capital else the government would have had to “step in.” Or why has Jamie Dimon, JPMorgan’s CEO, been required to testify before both House and Senate Committees about a loss of less than 3% of the bank’s $190 billion capital base? As further proof of government control of the banking system, the FDIC recently announced that, under its Dodd-Frank mandate, it is ready to take over any TBTF institution, “when the next crisis occurs.” Isn’t it clear that the relationship between the US federal government and the banking system is unhealthy, perhaps even incestuous, to the detriment of the private sector? That very same banking model is emerging in Europe with the emergency funding by the European Financial Stability Fund (EFSF) to recapitalize the Spanish banks and talk of a pan-European regulatory authority and deposit insurance.

The emerging banking model is one in which central governments and the money center banks co-exist in a mutual admiration society where government capitalizes the banks and the banks are the primary buyers of excessive government debt. Because government doesn’t create any real economic value (it regulates it and transfers it from one group to another), the domination of government assets on bank balance sheets in place of private sector assets spells real trouble for the future economic growth in the Western economies.

 
 
 
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

June 18, 2012

Why Greece is a big deal

Posted in Banking, Big Banks, Economy, Europe, Finance, greece, sovereign debt, Uncategorized tagged , , , , , , , , , , at 4:55 PM by Robert Barone

I’ve read in several different places that a Greek exit from the European Monetary union is not a big deal because Greece’s economy is small and represents only a small fraction of the economic output of the eurozone. Besides, it is already discounted in the markets. I disagree.Remember in the ’90s, when the Thai baht crashed, people said that Thailand was such a small part of Asia that there would be no fallout. But the fallout was huge because every country in the region had the same issues. This is clearly the case in the EMU. In reality, the issues in Portugal, Spain and Italy are the same as those in Greece. While I believe that there could come a time when Greece could exit gracefully, that time is not now because there is no process or set of rules governing such an exit.

Besides, if a sovereign country wants to exit, what, short of war, could prevent it? If Greece decided to exit now, it would repudiate its external debts and, as a result, banks and important European institutions could face insolvency. Greek society could deteriorate into chaos, including rioting, civil unrest and economic dislocation of many Greek citizens. Such contagion could well spread to Spain, Portugal, and even Italy.

Here’s some of the challenges Greece is facing:

• A return to the drachma means radical devaluation of the liquid assets held by Greek citizens;

• Greece imports all of its energy and most of its raw materials. Already, Greek utilities are in arrears to their Russian power suppliers because citizens are not making utility payments. And the Russians are threatening to cut off the power supplies;

• Money is already fleeing the country, so Greece would have to impose capital controls to further prevent money, capital and assets from fleeing, including restricting free access to and from the country via military operations;

• There would be significant impacts on Cyprus, or even on Turkey;

• The European Central Bank holds a huge volume of Greek bonds; in a chaotic exit, with Greek debt repudiation, the solvency of the ECB could be called into question (imagine, one of the world’s premier money printers having to deal with insolvency). Worse, the central banks of Germany and other stronger EMU countries will have to write off significant Greek assets, which have resulted from Greek citizens making euro deposits in the banks of these stronger countries.;

• There are implications, too, for the other external lenders like the International Monetary Funds and the European Financial Stability Facility;

• Bank runs, considered silent until now, would erupt in the other suspect countries (Portugal, Spain and Italy).

If Greece leaves the EMU under these conditions, what is to prevent Portugal and/or Ireland from doing the same? A Greek chaotic exit would make the capital markets skeptical as to whether the aforementioned countries plus Spain, and even Italy, could remain in the EMU. And the capital markets will test their resolve by raising rates in these countries to unacceptable levels until action is taken.

Portugal, Spain and Italy are repeats of Greece on a much larger scale. While aid from the other EMU countries for Spain’s insolvent banking system appears to have been forthcoming, at this writing, the terms of such aid have not been clearly established. Furthermore, the Spanish citizens are up in arms (literally) that the banks are being saved with nothing for the common citizen. And, if Spain’s banking Portugal’s, Italy’s or Ireland’s? Unfortunately, after Spain, the funding source, the EFSF, is essentially out of cash.

The Greeks go to the polls today and may elect leaders who will repudiate the austerity deals that the former government made in return for bailout funds. Or, as happened in the May elections, no one party may end up having enough influence to form a government. Furthermore, the Greek government is set to run out of money by June’s end. Let’s hope that Syriza’s party leader, Alexis Tspiris, if he heads the government, is just posturing about debt repudiation to get a better deal from the other EMU countries.

There are grave implications for the capital markets. The chaos and contagion in Europe could well spread to the U.S. financial system because, as we recently saw at J.P. Morgan, no one, including Jamie Dimon, knows what is on the balance sheets of the large U.S. banks. Any crack in the financial system foundation could well cause chaos even in the U.S. In addition, financial chaos always causes large equity market downdrafts.

Today’s elections in Greece are key, and the results of those elections will determine if Greece will even cooperate. If it doesn’t, sometime in late June or early July, it will run out of money. Given the track record of the European politicians, the probability appears low that Europe can avoid the chaotic Greek exit. Greece isa big deal, and I believe that we will find out just how big very soon.

 
 
 
Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor. Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
 
Universal Value 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 “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.
 
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, an SEC Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

May 24, 2012

Too Big to Fail: Four Years Later, Things Are Riskier Than Ever

Posted in Banking, Ben Bernanke, Big Banks, Europe, Federal Reserve, Finance, greece, investment banking, investments tagged , , , , , , , , , , , , , , , , , , , , , , at 7:58 PM by Robert Barone

The turmoil in Europe, trading losses at JPMorgan (JPM), and recent revelations about naked short-selling by Goldman Sachs (GS) and Bank of America-Merrill Lynch (BAC) should be giving every American and every policy maker heartburn because each and every one of these issues has potential to cause systemic financial shocks. It all ultimately comes down to the continuing saga of “Too Big to Fail,” or TBTF. TBTF nearly brought the financial system down in ’08 and ’09. It was supposed to be fixed by the Dodd-Frank legislation. But today, the TBTF institutions are even bigger than they were in ’08.

European Worries

On a daily basis, reports indicate that instability is growing in the European Monetary Union’s (or EMU) banking system. There have been outright runs on Greek institutions and rumored runs on Spanish banks. In Greece, it’s been reported that some businesses will not accept euro notes (i.e., the paper currency) issued by the Greek central bank for fear that if Greece leaves the EMU, those notes will be turned into new drachmas, which will be worth only a fraction of what real euros are worth.

In the US, the paper currency is issued by a Federal Reserve Bank. There is a number on each bill (1 to 12) that shows which Federal Reserve Bank was the issuer. Like the US, each participating central bank in the EMU can issue currency; the first letter of the serial number is coded to indicate which bank issued it. Currency issued by the Greek central bank is coded with a “Y.” Some Greeks are demanding currency coded with an “X” ( i.e., Germany).

There are growing worries about European bank solvency, and Moody’s recently downgraded a significant number of the larger Spanish and Italian banks. If Greece leaves the EMU, contagion could result. If funding markets for European banks freeze (causing one or several institutions to be unable to meet their daily liquidity requirements), there is a high probability that any contagion would spread to US financial institutions.

At the very least, the interrelationships between large US and European institutions will cause significant issues if a fat tail event occurs on the continent.

In fact, on March 21, Fed Chairman Bernanke warned Congress that the risks of impacts from such events on US banks and money market funds appeared to be significant.

Lack of Internal Controls at TBTF Institutions

On May 11, Jamie Dimon announced that JPMorgan had lost $2 billion or more in a failed “hedge” trade. Since then, the estimates of the loss have escalated; some think it could be as much as $5 billion – $7 billion. This shows that even the best-of-breed bankers, like Mr. Dimon, are unable to place sufficient internal controls over the riskiest of operations.

Over the past several years, we’ve seen such trading blow-ups at several of the TBTF institutions. The so-called “Volcker Rule,” a portion of the Dodd-Frank legislation that is supposedly effective this fall, should prevent “proprietary trading” at the TBTF institutions. But many think that such rules will be easy to get around; Mr. Dimon has indicated that this huge loss was due to a failed “hedge,” and not proprietary trading. JPMorgan had $182 billion in capital according to their March 31 filings, so the loss of a few billion isn’t going to put this institution in any danger or require any taxpayer assistance.

However, on the Monday after the JPMorgan announcement (May 14), President Obama appeared on ABC’s The View and commented that it was a good thing that JPMorgan had plenty of capital, noting that had this happened at a weaker bank, “[W]e could have had to step in.”

Think about this statement. The first reaction to stress in the financial system is for the government to step in! Compare that to the first Chrysler bailout in 1979. At that time, Lee Iacocca, Chrysler’s Chairman and CEO, had to beg Congress for nearly four months for a loan guarantee (not a direct loan) of $1.5 billion.

In fact, the day before Mr. Dimon announced JPMorgan’s large loss problem, the FDIC’s acting Chairman, Martin Gruenberg, announced plans and procedures for the FDIC to seize large financial institutions “when the next crisis brings a major financial firm to its knees.” Instead of getting rid of TBTF, it is now institutionalized. The FDIC’s announced plans are simply in accordance with Dodd-Frank.

During the week of May 14, the lawyers representing Goldman Sachs and Bank of America-Merrill Lynch in a lawsuit filed by Overstock.com filed an unredacted set of documents with the court (i.e., the whole document was submitted instead of only certain parts), thus putting them into the public domain.

Those documents revealed that these TBTF institutions knowingly ignored the laws and regulations against “naked” short-selling. When one sells “short,” one must first borrow the stock, or else there is nothing to prevent someone shorting (i.e., selling) so many shares as to significantly and negatively impact the market price for the stock (which is what a short-seller hopes for). “Naked” short-selling occurs when the stock is sold without borrowing it from another owner, and three business days later, the seller “fails” to deliver the stock.

Because of their size and power, the TBTF banks could depress the stock price of any company they choose. If one of their units puts a “sell” recommendation out and the trading department “naked” short-sells, then the “sell” recommendation becomes a self-fulfilling prophecy. This, in fact, is what Overstock.com’s lawsuit has been about.

So let’s review:

1. Bernanke worries that European bank insolvencies or liquidity issues may have significant systemic impacts on US financial institutions – if anyone knows, he should know.2. JPMorgan’s losses elicited a response from the US president about the immediate active role of government with regard to issues at the TBTF banks.3. The FDIC announced its policies, plans, and procedures to seize TBTF institutions when the next financial crisis occurs.

4. It has come to light that some TBTF institutions have skirted laws and regulations.

If there were no TBTF institutions in the US, then little of the above would be of concern. Instead:

1. While the European contagion would still be a worry, it wouldn’t be as much of a worry regarding its risk to our entire financial system because no one institution alone would be a systemic risk.2. The government shouldn’t ever have to “step in” if a bank failed. Sure, there would be market reaction and shareholders and bondholders would have consequences, but as long as the failed institution couldn’t cause systemic issues, there would be no need for government (taxpayer) involvement.3. The expensive and extensive policies and processes now being set up at FDIC would be unnecessary.

4. Without the power that comes with being TBTF, the “naked” short-selling and other abuses would be much less effective or profitable.

5. The TBTF institutions are so complex that even the likes of a Jamie Dimon can’t provide effective internal controls and risk management. Smaller institutions that have such issues won’t cause systemic risk.

The lessons of the ’08-’09 near systemic meltdown were clear: TBTF is a huge policy issue. Unfortunately, after Dodd-Frank, not only are TBTF institutions bigger and systemically more risky, but we now have a government all too willing, and maybe even eager, to “step in.”

 

Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor.  Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
 
Universal Value 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 “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, an SEC Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the
Investment Committee.

Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

May 21, 2012

Rebellion Against Austerity From Greece To Washington

Posted in Economy, Europe, government, greece, investment banking, investments, QE3, recession, Uncategorized tagged , , , , , , , , , , , , , at 10:38 PM by Robert Barone

Since the initial euro crisis erupted in Greece two years ago, I have speculated that the necessary move toward austerity would be sidetracked by a political response from the impacted populations, which would elect leaders who promised a move away from such austerity. I didn’t realize how rapid and rabid the response would be.
 
The table below shows a list of headline anti-austerity movements, and, yes, I’ve included such movements in the U.S.
 
Country
Anti-Austerity Development
France The May 6th election of Hollande, a leader who promised more government spending, higher taxes and a reduction in the retirement age, at a time when budget deficits and austerity are key issues.
Greece Greek voters flocked to anti-austerity parties during the May 6th elections, stoking concern in Europe that austerity may be derailed.
Ireland Sentiment has turned sour on austerity with elections scheduled this spring.
Argentina Nationalization of Spanish owner Repsol’s (REP) 51% stake in YPF (YPF), a major oil producer.
Bolivia Seizure of Spanish power grid operator Red Electrica’s (REE.MC) 57% ownership of a Bolivian power line company which controlled 85% of the power lines in the country.
Spain Inability (or lack of determination) to meet promised austerity targets.
U.S. Political attack on the so-called wealthy and on cash rich corporations for not paying their “fair share” of taxes, in order to keep from having to cut spending.
 
Much of the backlash is occurring because governments can no longer fulfill the promises made, whether they be in transfer payments, services, or salaries and benefits, etc., due to shortfall of revenue and a remarkable growth in public debt burdens. As is clear now, it is one thing for politicians to talk about austerity, and another to live with the immediate consequences, often resulting in higher unemployment and recession.
 
Europe
 
Naturally, the hotbed of anti-austerity is Europe where they have long lived the entitlement life. Europe is clearly in recession, and it appears that it will be a long and deep one. The latest data from Europe shows that the Purchasing Managers’ Index (PMI) for March was 43.8 (where 50 is the line of demarcation between contraction and expansion). In Spain, now officially in recession, the PMI was 43.5, and in depression wracked Greece, it is 40.7. The manufacturing indexes in Europe are also contracting. The manufacturing PMI in France in March was 46.9, and even in mighty Germany, the manufacturing index was 46.2.
 
Spain’s unemployment rate is over 24%; Greece’s more than 21%. In Europe, the number of unemployed stands at 17.4 million, an increase of more than 1.7 million in the past year. The official unemployment rate in the European Union will soon surpass 11%. So, it isn’t any wonder that those politicians that have adopted the Robin Hood approach have gained populist support. After all, politics are politics – and populations used to entitlements naturally vote for candidates that promise to give them something, usually by taking it away from someone else.
 
When the European Central Bank (ECB) embarked upon its Long Term Refunding Operations (LTRO1 and LTRO2), which gave all European banks access to 1% money for 3 years in order to stave off a rapidly approaching financial crisis in those banks, there was an unwritten quid pro quo. The bargain was the liquidity to stave off the financial crisis, and, in return, the member countries would have to embark upon a path of fiscal reform–austerity–that is now being unwound.
 
The question is, will the ECB continue along this money printing path to stave off the next phase of the financial crisis if the member countries have shunned their part of the bargain? Or, will the new and emerging concept of a European “growth pact” give the ECB the political cover it needs to continue printing. I suspect the latter.
 
The concept of a “growth pact” is nothing new to Europe. Austerity in the ’90s morphed into the “Stability and Growth Pact” (SGP), and it appears to be doing so again. The idea is to have the economy “grow” so that tax collections rise and deficits are reduced. Who can oppose that idea? Unfortunately, there is little that the European governments can do pro-actively to spur such growth.
 
The best thing would be to get out of the way of the private sector, but such ideas are anathema. Nevertheless, the Keynesian hope is that more deficit stimulus and more money printing with less austerity will prove to be the cure. I doubt this approach will be anything more than further can kicking. Furthermore, it is a dangerous game, especially in the hands of politicians, because even the “growth pact” still demands discipline in the budget and spending process.
 
In Greece, no government has been formed from the May 6th election results which pits polar opposite political views among the highest vote getters. The leader of the party with the second most votes ran on a platform to renege on the austerity agreements already in place with the external financing partners, to raise public pension payments and salaries, etc. And that leader seems to have gained even more popularity for the upcoming June elections. At current spending rates, Greece will run out of funds to pay its obligations by the end of June. And, it will be up to the Troika (European Commission, European Central Bank, and International Monetary Fund) to determine if Greece will get its next tranche of external financing (i.e., loans).
 
It appears that Europe is moving perilously closer to financial chaos. A Greek default on its external debt could easily result in a disorderly withdrawal from the EMU (European Monetary Union), which could trigger worldwide financial instability. Imagine if you were a Greek citizen and you woke up one morning to find that the euros in your local bank had been converted to new drachmas on a 1:1 basis. Later that day you discover that your new drachmas are worth substantially less than the euros you had yesterday. People aren’t dumb. Over the past few months, we have observed, through the borrowings at the ECB, a growing silent run on European banks in the at-risk countries (Spain, Italy). Italy even limited the amount of cash a bank can give its clients. And now, there is an outright run on Greek Banks.A Greek dismissal or withdrawal from the EMU along with its default on external debt is likely to trigger massive outright runs on Spanish, Italian and other weak European banks. The domino effects of this are unknown – all the way from other weak EMU partners electing the Greek path to a complete implosion of the EMU. The impacts will be worldwide. Expect volatility in markets and significant U.S. dollar strength.

 
The Americas
 
The U.S. isn’t too far behind Europe in the entitlement game as it has caught up rapidly over the past decade. But, in the U.S., the anti-austerity movement has taken a slightly different track. The ploy here is to avoid the basic issue of federal government overspending, over indebtedness and over promises. So, the greedy and evil corporations, which “evade” just and fair taxes, are blamed for the deficit because they refuse to pay their “fair share.” And those same corporations that “hoard” cash are responsible for lack of job growth because they won’t spend and invest those cash hoards.
 
The simple truth is that Apple (AAPL), Microsoft (MSFT), Wal-Mart (WMT), and all of the others are simply playing the tax game that was written and is orchestrated by none other than the politicians themselves. In what remains of our capitalist system, corporate managers are supposed to maximize profits, and one doesn’t do that without uncovering every dollar-saving loophole written into the tax code.
 
As for the cash, much of it remains offshore because it would be taxed if brought back. But it remains unused because of the ongoing uncertainties today’s politicians have imposed. No tax law is now permanent or at least has a long enough life for corporate managers to make prudent investment decisions. Most have a one or two year life (Bush tax cut extensions, payroll tax reduction, depreciation laws, etc.). Without some certainty about the tax code, about deficits, or about the cost of energy, those cash hoards simply won’t be invested – at least not in the U.S or other slow growth industrial countries.
 
This rhetoric is really a diversion from the real issue of too much debt, unsustainable deficits, and living beyond our means. The size of government is being addressed at most state and local levels (even by Jerry Brown in California, but definitely not at the federal level.
 
Unfortunately, the movement away from austerity either prolongs the crisis, or makes it ultimately worse. In Bolivia, the series of nationalizations that began in ’06 (natural gas fields) are now causing capital formation issues. The gas wells are producing less, as is the normal course for such wells, but there is no internal capital for new exploration (all the capital that could, fled long ago), and foreign capital simply won’t go there based upon the last six years of political behavior and private sector confiscation (besides Bolivia, the other Latin American countries with extreme left wing governments are Venezuela, Argentina, Ecuador, and Nicaragua).
 
As is evident in places like Bolivia and Venezuela, the move away from austerity via class warfare, confiscation, and nationalizations only prolongs the economic problems, usually making them far worse than the original austerity would have imposed.
 
Conclusion
 
The point is, “taxing the rich,” attacking successful corporations, nationalizing industries, or simply allowing government to pick the winners and the losers does nothing to create economic growth or jobs. It does just the opposite. Austerity, in some form, is necessary to pay back the over borrowing and over consuming of the past. There is no way around it.
 
Printing more money, running high deficits and taxing the productive members of society will not fix the growth and jobs issues. Rejecting the necessary austerity will just exacerbate the problem(s) or shift the burdens to other unsuspecting citizens, like seniors, retirees, or onto future generations through high or hyper inflation.
 
Erskine Bowles, a Democrat, co-chair of President Obama’s Commission on Fiscal Responsibility and Reform, and co-author of the Simpson-Bowles fiscal plan said this to the Council on Foreign Relations on April 24th:
 
Without serious debt reduction, it won’t take much of an increase in interest rates to create a fiscal crisis for the country the likes of which only those who lived through the Great Depression can recall. Once interest rates reach a level that reflects the genuine risk inherent in our ongoing fiscal mismanagement, and debt service eats up more and more of a shrinking pie, the financial crisis we just lived through (and are still living through) will seem like a sideshow… Deficits are truly like a cancer and over time they are going to destroy our country from within.
 
Most industrial countries with large fiscal deficits have a choice between something bad (austerity now) and something awful (high inflation, hyperinflation, social upheaval, or worse). While no one likes austerity, the consequences of choosing to kick the can further down the road are much worse. Yet, that is clearly what is happening with likely dire financial consequences, perhaps as soon as Greece formally defaults. Nonetheless, at this particular moment, “austerity” has become just another dirty word.
 
Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor.  Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
 
Universal Value 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 “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, an SEC Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.

Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.