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.
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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.

April 24, 2012

After further review, employment remains unhealthy

Posted in Economic Growth, Economy, Federal Reserve, Finance, investment advisor, investment banking, investments, recession, Uncategorized, Unemployment tagged , , , , , , , , , , , , , , , , , , , , at 3:40 PM by Robert Barone

 Most of the business media is content to rehash headline data, simply passing on what the large wire services report with no further analysis. The headline, then, becomes the “conventional wisdom.”

Such was the case on the first Friday of April with the reporting of the unemployment rate. The conventional wisdoom was that there was some disappointment in that, using the Establishment Survey of the Bureau of Labor Statistics (BLS), the nation only created 120,000 new jobs. But the unemployment rate itself sank to 8.2 percent. For that we should be grateful, at least according to the conventional wisdom.
 
The accompanying chart tells quite a different story. It is a long-term chart. The period measured (horizontal axis) begins in 1988, so it covers about a quarter of a century. The right hand vertical axis measures the “headline” unemployment rate. That’s the headline rate most often reported. In government jargon, it is known as the U-3.
 
The scale is inverted, so a rising line means the unemployment rate is falling. This unemployment rate is supposed to measure the number of people looking for work who can’t find it as a percentage of all people with and without jobs. The left hand scale is a measure of the employment rate in its most basic form. Most readers won’t recognize this, as it is seldom reported, but it measures the number of people employed as a percentage of the population. As such, it is a better measure of the job market in that, unlike the unemployment rate, its definition can’t be changed (more on that later).
 
Looking at the chart, note that in the late 1980s, 63 percent of the population was employed. This rose to nearly 65 percent at the turn of the century. After falling to 62 percent in the 2001-02 recession, it rose back to 63 percent in 2007. Since the Great Recession, this measure of employment has been bottom bouncing just above 58 percent.
 
But what is really noticeable is the huge divergence between the two since 2010. The question to be asked is, “How can the ’employment rate’ show little to no improvement, while the ‘unemployment rate’ would lead one to conclude something altogether different?” The answer lies in how things are defined.
 
In 1994, BLS redefined the term ‘discouraged worker.’ This person was counted as unemployed only if he or she had been ‘discouraged’ for less than a year. After that, he or she was longer counted as ‘looking for work.’ Today, with jobs so hard to find, we clearly have many people who have been out of work for more than a year but are still actively seeking employment. Our social safety net even recognizes jobs are hard to find – unemployment insurance payments are available for 99 weeks. But our measurement of “unemployment” stops counting people as unemployed or even looking for work after 52 weeks. They are simply defined away! This goes a long way toward explaining the increasing discrepancy between the two series.
 
This past weekend, I made an off-the-cuff observation to my wife as we visited a fast food establishment with the grandchildren in tow. I noted employees seemed to be a lot older than what I remembered from a few years back. In recent blogs, both David Rosenberg (Gluskin Sheff) and John Hussman (Hussman Funds) wrote about the changes in the distribution of job creation since the end of the recession in June 2009. According to the Federal Reserve Bank of St. Louis, total employment in non-agricultural industries (seasonally adjusted) has grown 2.15 million since that time. For workers 55 and older, employment has grown by 2.98 million.
 
That means that employment has continued to contract for those under 55 years of age since the recession’s so-called end! How can that be healthy?
 
There is a term business media uses called “financial repression.” Essentially, it refers to the zero interest rate environment in which savers and retirees are no longer able to live off the interest on assets they accumulated prior to retirement. So they re-enter the labor force, working for minimum wages to supplement now inadequate retirement incomes.
 
The employment picture, then, when viewed from this lens, is much worse than the headline data and conventional wisdom would have you believe. I don’t think this is a surprise to most Americans, but it would certainly help if the business media stopped pretending.
 
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.

April 9, 2012

Financial armageddon: Should you worry?

Posted in Armageddon, Banking, crises, debt, Economic Growth, Economy, Finance, government, Housing Market, investment advisor, investment banking, investments, IRS, medicare/medicaid, Nevada, payroll tax reductions, recession, social security, taxes tagged , , , , , , , , , , , , , , , , , at 8:37 PM by Robert Barone

You’ve probably seen them in your email, or even on TV — I’m talking about the “approaching financial armageddon” forecasts. People must be responding to them, because they keep on appearing in my email — several per week, and others I know get them too. Should you be concerned?To answer this, we examine data from the six largest categories of Federal expenditures in 2000, 2012, projections for 2016, and their associated compounded annual growth rates (CAGR). Much of this data comes from USdebtclock.org. Caution, the website is not for the faint of heart.Six expense categories (Medicare/Medicaid, social security, income security, federal pensions, interest on debt and defense) account for nearly $3.1 trillion of spending in 2012, represent more than 86 percent of total federal spending and account for 137 percent of taxes collected. These six spending categories are critical when trying to understand the nature and extent of the structural deficit.Growth rates in CAGR show Medicare/Medicaid spending growing to $1,050 billion per year in 2016. The demographics of the U.S. population don’t show us getting younger and baby boomers are just beginning retirement. Social Security will also advance much more quickly than its 5.4 percent growth rate of the past 12 years. All in all, the projection of expenses I’ve shown in the table for 2016 ($3,692 versus $2,265 in 2012) appear quite optimistic. But, let’s go with it.Americans, in general, will tell you they oppose bigger government, at least in the abstract. But in poll after poll, when asked where Congress should make significant cost cuts, almost no specific program eliminations are favored by a majority of Americans. Given this predilection among Americans and assuming that these six categories again account for 86 percent of Federal spending in 2016, then, total Federal spending will be approximately $4.3 trillion.

Some analysts fret about the “fiscal cliff” on Jan. 1, 2013 when the Bush tax cuts are scheduled to expire along with the 2 percent payroll tax reduction for individual social security contributions.

Those analysts put the impact of these at a 3 to 4 percent GDP reduction. When the Bush tax cuts expire, the Federal government theoretically could collect about $300 billion more in taxes if economic activity were otherwise unchanged (a heroic assumption). In addition, the reinstatement of the 2 percent social security tax on individuals will add about $160 billion to tax revenues (again, assuming no decline). The breakout with this story is an estimate of what the deficit would be and its relationship to 2016 GDP. It assumes the Bush tax cuts have been eliminated, the payroll taxes are reinstated, and economic activity is not negatively impacted, so it is likely to understate the deficit. The tax revenue growth rates (left hand column) begin in 2013, after the “fiscal cliff.”

As you can see from the table, reinstatement of the Bush tax cuts and the payroll tax reductions alone do little to solve the issue, as the deficit remains at $1.54 trillion if no further tax increases occur.

 

OUR ‘FISCAL CLIFF’

If Tax CAGR is: Deficit/GDP will be: Deficit will be ($trills):
0% 9.1% $1.54
5% 6.6% $1.12
7% 5.5% $0.93
8% 4.9% $0.83
10% 3.7% $0.63
16% 0.0% $0.00
 
Such a tax regime will clearly keep the economy in a no growth or recessionary mode. If America resists the tax increases, then deficits will balloon, interest rates will rise as the world spurns the dollar, the Fed will continue to print money and purchase the debt that can’t be placed externally, a nasty inflation will likely set in (it has already begun — look at food and energy prices), and we will find ourselves in a Greek type tragedy. The only way out is to significantly cut the growth of Medicare/Medicaid, Social Security, Income Security and Federal Pensions. Which Congress and president will do that?So, should you be concerned about an approaching financial armageddon? Yes.
  

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.

 

March 26, 2012

Robert Barone: Is U.S. housing healing?

Posted in Banking, Big Banks, debt, Economic Growth, Economy, Finance, Foreclosure, government, Housing Market, investment advisor, investment banking, investments, Nevada, recession, Uncategorized tagged , , , , , , , , , , , , , , , , , , , at 5:15 PM by Robert Barone

Last Tuesday, a headline in the business media read: “U.S. housing heals as starts near three-year high.”
I scratched my head. The last three years have been the worst in recorded U.S. housing history. The accompanying chart tells the story. It is a real stretch to believe that this data indicates “healing.” Worse, everybody knows that the extremely mild winter has pulled demand forward; this is especially true for housing starts, as contractors don’t pour foundations in freezing weather, but use mild periods in the winter to get a head start for spring sales.
The data shown in this chart is “seasonally adjusted,” a statistical process that attempts to normalize fluctuations in data caused by such things as weather or holiday shopping. The seasonal adjustment process assumes January and February have typical winter weather. So, if the mild winter caused contractors to pour more foundations than they would have in a normal winter, then the seasonal adjustment process overstates what would be a normalized level of housing starts.
There is a similar story for sales of existing homes — the data was released last Wednesday. Because of the weather and other significant issues, I suspect that new starts and sales (where the “seasonal factors” normalize to the downside) will disappoint in the months ahead. Here’s why:
There are 3 important price categories: less than $300,000; $300,000 to $800,000; $800,000 and above.
There are three important buying groups: first-timers; move-ups; retirees. Generally, the first-timers purchase the under $300,000 homes, while the move-ups purchase in the other two categories. Retirees, usually sell from the upper two categories and “downsize.”
Government stimulus programs and record low interest rates have made homes the most affordable in decades (current index = 206; 100 means that a median income family can afford a median income home). First-time buyers can get a low down payment low interest rate loan (what happens if interest rates rise?), but those in the move-up category must rely on traditional bank-type financing, which requires a big down payment.
The home price downdraft since 2007 has taken many of the move-up buyers out of the market. CoreLogic data shows that 50 percent of current U.S. homeowners (the move-ups and the retirees) have less than 20 percent equity in their homes. That means that a significant percentage of move-ups cannot sell their existing home, pay a realtor’s commission (usually 6 percent), and have a 20 percent down payment for the move-up property.
History shows a healthy housing sector is critical to U.S. economic growth, and that when the move-ups are not healthy the sector does poorly.
Retirees are finding their homes are not worth what they thought. Their tendency is to stay put and wait for a better market. In fact, the media hype around “healing” is probably keeping them in their homes, as they now believe that a better market is just ahead! This is called “shadow” inventory, which means that the number of homes officially for sale understates the real supply.
With this view, we would expect the low-priced homes to be doing well but the upper two price brackets to be doing poorly. February data from Dataquick for the Southern California housing market confirms this view. First-time buyer price point sales (under $300,000) are up 9.5 percent from a year earlier, while the other two price point sales are both down (the $300,000 to $800,000 down by .8 percent, and the $800,000 and above down by 12.6 percent).
Nothing in this data, from the seasonal adjustment bias to the health of two of the three buying groups, tells me U.S. housing is healing.

March 15, 2012

Markets Hooked On Liquidity Drug From Central Bank Pushers

Posted in Banking, Ben Bernanke, CDS, Economy, Europe, Federal Reserve, Finance, Foreign, government, investment banking, investments, ISDA, QE3, recession, sovereign debt, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , at 10:04 PM by Robert Barone

From early last October to the end of last month, the S&P 500 rose 25%; amazing for an economy that is struggling to stay out of recession.  Then again, the equity markets are hooked on the liquidity drug.

When Federal Reserve Chairman Ben Bernanke, in his recent semi-annual testimony before Congress, did not hint that QE3 was just around the corner, the market sold off.  When the European Central Bank broke its traditional role as lender of last resort and morphed into a gift giver to its member banks (to the tune of more than a trillion dollars), much like our Fed, the equity markets soared.

Money printing can’t go on forever, can it?

In every historical context, whenever the equity markets have a run up not based on economic fundamentals, eventually, they return to what those fundamentals dictate.  And here are some of the underlying economics:

  • There is no doubt that American manufacturing is undergoing a renaissance.  Labor costs in Asia are on a steep rise while wages here have been stagnant for several years.  Shipping costs, quality control and culture are other factors.  But, manufacturing represents less than 12% of GDP.  It, alone, cannot drive significant economic growth.
  • Gasoline prices are up more than $.60/gallon year to date with talk of $4.50 gas by summer. That cost/gallon is already here in some markets. Every penny increase drains $1.5 billion annually from other consumer discretionary spending.  That’s about $90 billion so far for 2012.  And what happens to gas prices if the Middle East flares up again?
  • While the first quarter is far from over, early data suggest a much softer than expected GDP.  Retail sales have been soft except for automobiles (pent-up demand or just a rush to buy fuel efficient vehicles ?).  Consumers (70% of GDP) have shown no real income growth for many quarters, and incomes are tumbling in Europe.  Inventories appear to be on the high side given the level of demand.  So additional production won’t be forthcoming.
  • Despite a reinstitution of 100% depreciation for capital equipment, much of that demand was pulled into 2011, as the business community was uncertain as to whether or not the tax break was going to be reinstated in 2012.    The state and local government sector is still in contraction, and, given the slowdown evident in the rest of the world, exports aren’t likely to add to GDP.  Of course, the market may like the softer side of GDP, as it likely ensures another dose of the liquidity drug from the money czar, Bernanke, the king of money printing.
  • Europe is sicker than the markets have priced in.  The hoopla around the Greek bailout is just another can kicking.  Because the Greek populace hasn’t accepted the idea that they have lived beyond their means for the past decade, austerity won’t be successful.  Politicians who promise to end the austerity are likely to be elected.  Eventually, Greece will need to have their own currency which can fluctuate in value vis a vis other currencies with commensurate interest rate levels.
  • It is rare that all of Europe is in recession at the same time.  The current market expectation is that Europe’s recession will be mild.  But, don’t forget, Germany’s biggest export clients are other European countries.  In fact, as a general rule, all of Europe’s economies export heavily to each other.  Being in recession together is going to have a large impact on those exports.  In addition, if the Euro remains at its current lofty level (above $1.30), it will be more difficult to export to non-EU countries.
  • The determination by the ISDA (International Swaps and Derivatives Association) that Greece officially defaulted on its debt when it invoked its recent legislatively passed “Collective Action Clause” to force investors to take losses is actually good news for the other so-called troubled European sovereigns (Portugal, Spain, Italy, Ireland) because it assures private sector investors that if they buy the so-called troubled foreign sovereign bonds, hedge them with Credit Default Swaps (CDS) and a Greek style default occurs, they will be paid at or near par value.  If the CDS payout had not been triggered, the private sector investors would view the purchase of such sovereign debt as having significantly more risk, and that would result in a much higher interest cost of that sovereign debt to the issuing countries.  In addition, it would throw the whole CDS concept into confusion, potentially impacting even the higher quality sovereigns like, Germany, the U.K., Canada, Australia, and even the U.S.
  • This is not to say that the world is now safe from financial contagion, as, in the context of world markets, Greece’s default is an expected and well prepared for event. The real worry should be if Spain (debt > $1 trillion) and/or Italy (debt> $2 trillion) default.  In addition, the CDS market is not transparent, and no one knows where the CDS obligations lie.  While a Portuguese and/or Irish default would have about the same individual impact as that of Greece (economies slightly smaller and not as indebted), we should worry that a rolling set of smaller defaults would eventually cause a major CDS insurer to fail due to the cumulative impact of the several defaults.  After all, it is likely that the CDS insurers who dabbled in Greek CDS, are also involved in CDS insurance of the other high debt European countries.  And, if a significant CDS insurer defaults (e.g., an institution similar in size and stature to AIG in 2009), we could, indeed, have contagion.
  • But even ignoring Greece for the short term, the ECB’s LTRO 1 and 2 appear to make Europe’s banks even more vulnerable.  Unlike the Fed, which purchased questionable assets from bank balance sheets and put them on its own, the ECB has not followed suit.  In fact, it stepped in and, by force majeure, inserted itself as senior to other bondholders holding the exact same Greek bonds, thus avoiding any losses in its own portfolio.  That makes losses for the private sector even greater.  Worse, it sours potential investors in European sovereign debt, seeing that they cannot easily quantify their risks as they can’t know how much of the same sovereign debt they own may be owned by the ECB.  This partially reverses the positive impact that the triggering of the CDS default will have on the European sovereign debt market.
  • Finally, the LTROs may make European banks even more insolvent than they are now, as they have been encouraged to take the cheap ECB funding and purchase European sovereigns for the interest spread (by Basle II and III rules, the debt of the European sovereigns is “riskless” and requires no capital backing on a bank’s balance sheet)!  Further sovereign debt crises, e.g., Portugal, Spain, or Italy, will eat away at already scarce European bank capital.  Contagion could very well result.

Looking at the GDP of Europe relative to China, if one includes all of the European Union countries and those closely related, Europe’s economy is about twice the size of China.  If China’s GDP growth went from 9% to 3%, the equity markets would certainly have a huge sell off.  But, it is likely that Europe’s GDP will fall from about 1.5% in 2011 to -1.5% in 2012, maybe even more than that.  Do the math!  This is equivalent to a Chinese hard landing.  As the European recession unfolds, the equity markets are likely to wake up.

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Speaking of China, a slowdown is clearly developing.  They actually ran a trade deficit for the first two months of 2012 signaling a real slowdown in exports.  Retail sales have been softer than expected and the real estate bubble there appears to be in the process of popping as property sales and prices are plunging.  No wonder the government recently lowered its official growth forecast from 8% to 7.5%.  This is not to say that China, itself, is entering a recession, but a slower growth rate there (2nd largest economy) in combination with growth issues in the US (largest economy), Japan (3rd largest), and a significant recession in Europe bodes ill for worldwide growth and will eventually play out in the equity markets.

The profit implications for multinational corporations of the severe recession in Europe, and a slowdown in China and elsewhere are significant.  Analysts have continued to forecast rapid earnings growth and high profit margins even in the face of rising energy and food costs and stagnant U.S. and falling European incomes.  Using such rosy profit forecasts makes the market look undervalued.  However, a 15% – 20% profit decline is normal for a recessionary world.  If you plug that in, the equity markets look overvalued today.

Wasn’t it somewhere around this time last year that the equity markets were also priced for perfection?  Didn’t we hear that the economy had achieved “escape” velocity and that the recovery was about to accelerate?  And, didn’t the market sink when the economy fizzled and needed the QE2 liquidity drug injection?  In fact, the S&P 500 ended 2011 at exactly the point where it began, with a lot of volatility in between.  So far, 2012 appears to be following 2011′s path.

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, GeorgetownUniversity) 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.

 

March 13, 2012

Greece Default Declaration Stabilizes CDS Markets

Posted in Banking, Bankruptcy, Big Banks, Bonds, credit default swap, debt, derivatives, Economy, Europe, Finance, Foreign, government, International Swaps and Derivatives, investment advisor, investment banking, investments, ISDA, Nevada, sovereign debt tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 3:10 PM by Robert Barone

NEW YORK (TheStreet) — The determination by the International Swaps and Derivatives Association that Greece officially defaulted on its debt when it invoked its recent legislatively passed “Collective Action Clause” to force investors to take losses is actually good news for the other so-called troubled European sovereigns like Portugal, Spain, Italy and Ireland.

The ISDA determination assures private sector investors that if they buy the so-called troubled foreign sovereign bonds, hedge them with credit default swaps and a Greek style default occurs, they will be paid at or near par value.

If the CDS payout had not been triggered, the private sector investors would view the purchase of such sovereign debt as having significantly more risk, and that would result in a much higher interest cost of that sovereign debt to the issuing countries. In addition, it would throw the whole CDS concept into confusion, potentially impacting even the higher quality sovereigns like, Germany, the U.K., Canada, Australia, and even the U.S.

According to the ISDA, about $3.16 billion of Greek debt is covered by the CDS (4,323 swap contracts). On March 19, an auction will be held which will set the “recovery” value on the Greek bonds. The difference between that recovery value and par will be the payout of the CDS.

For example, if the auction results in a recovery value of 20%, then the CDS payment will be 80%, or about $2.5 billion. This is not a large amount in the context of world markets, and it would be a surprise if any viable CDS issuer will be greatly impacted, although it does appear that Austria’s KA Finanz, the “bad” bank that was created in 2008 when Kommunalkredit Austria AG was nationalized and given all of the “distressed” assets, will be stuck with CDS losses in excess of $550 billion which will require the Austrian government to step up with a significant capital injection.

The “non-eventness” of the CDS payouts is a result of the fact that there has been a long lead time for the issuers to adjust their risk portfolios to deal with the likelihood of a Greek default. Over the past year, the amount of Greek debt covered by the CDS has halved. Compare this to the Lehman default of $5.2 billion where there was almost no lead time between the emergence of the Lehman issue and its bankruptcy filing.

It was the lack of such a lead time that caught CDS issuers, like American International Group(AIG), with no time to adjust their risk portfolios, and required government intervention to prevent a domino default effect. With Greece, no such domino effect is expected although there is always the possibility (albeit low) of a surprise. We will know that soon after the March 19 auction when settlement must occur.

This is not to say that the world is now safe from financial contagion, as, in the context of world markets, Greece’s default is an expected and well prepared for event. The real worry should be if Spain, with a debt of about $1 trillion and/or Italy with a debt of about $2 trillion default.

In addition, the CDS market is not transparent, and no one knows where the CDS obligations lie. While a Portuguese and/or Irish default would have about the same individual impact as that of Greece (economies slightly smaller and not as indebted), we should worry that a rolling set of smaller defaults would eventually cause a major CDS insurer to fail due to the cumulative impact of the several defaults.

After all, it is likely that the CDS insurers who dabbled in Greek CDS, are also involved in CDS insurance of the other high debt European countries. And, if a significant CDS insurer defaults (e.g., an institution similar in size and stature to AIG in 2009), we could, indeed, have contagion.

March 9, 2012

Wall Street gives Hayes the runaround

Posted in Banking, Big Banks, Business Friendly, community banks, Economy, Finance, government, investment advisor, investment banking, investments, local banks, Nevada, Stocks, Uncategorized tagged , , , , , , , , , , , at 4:08 PM by Robert Barone

The S&P 500 closed at 1,342 on Feb 10. It was at that level in May 2008, January 2001 and June 1999. For nearly 13 years, investors in America’s largest companies have essentially made little return on their investments.
But think about all the multi-millionaires and billionaires Wall Street has created f rom within its own ranks in that time span! It’s almost as if the game is rigged against the small investor.
Unfortunately, it is.
M.F. Global, for example, pledged and lost its clients’ assets in a bet on Italian bonds. Had the bet paid off, the firm and its management stood to benefit, not the clients. Yet the clients were on the hook when the bet went sour. In 2009, the government used taxpayer dollars to save the “Too Big To Fail” banks (which have since grown by more than 25 percent), or those in trouble because they had grossly over-levered their balance sheets. As if nothing had happened, in 2010 these institutions paid their management record bonuses ($1 million is chump change).
There is story after story in the investment world of small investors being bilked out of their hard-earned assets. It’s largely due
to a system that always puts the clients last. Here are some examples:
Outside Managers: Oftentimes, broker/dealers and/or supposed investment firms send client assets to outside managers. The client has to pay double fees – one set to the investment firm and another set to the outside manager. The outside managers often rebate part of their fees and expenses to the investment firm. Worse, the outside managers direct their discretionary purchases and sales, especially in bonds, back to the introducing firm’s trading desk. That desk, knowing full well there will be no competitive bid from other trading desks, adds a significant mark up or down from the true market price.
Shelf Space: In order to be available to clients, the large broker/dealers require smaller mutual funds to pay a monthly fee. In addition, all of the funds must rebate to the broker/dealer all or part of the 12b-1 fee that they charge as part of their expenses where these are split between the firm and the account rep.
In today’s world, there is absolutely no reason to pay a front end or back end “load” for a mutual fund. Yet many clients of the large broker/dealers pay loads as high as 5 percent, much of which is retained by the broker/dealer. If you are being charged a “load” when you buy mutual funds, ask yourself if your interests are being put first. Vanguard funds are widely known for having no loads (or 12b- 1 fees) and their expense ratios are among the lowest in the industry. Ask your account rep if you can buy Vanguard funds in your account. If the answer is no, consider whose interests are being put first.
Inappropriate Investments: This is really the biggest issue for small investors. Because of the cost of litigation, most small investors who have lost significant sums due to inappropriate investments cannot afford to fight a legal battle to recoup losses. Most of the time, inappropriate investments occur because the fee to the selling agent or institution is so significant that the clients’ best interests are put behind those of the firm or the account rep. A good practice is to ask your account rep the amount of commission associated with any particular trade.
The accompanying news story about Bobby Hayes of Incline Village, his local attorney, Thomas Bradley, and his broker/dealer Merrill Lynch (now Banc of America Securities) illustrates many of these points:
• In July 2007, Mr. Hayes told his account rep he didn’t want to take any risk with $883,122. His account rep put him into a high risk tranche of a collateralized mortgage obligation. If the value of the assets in the tranche fell by as little as 0.5 percent, Mr. Hayes’ investment would be wiped out. (During the last decade, Wall Street’s financial “rocket scientists” divided up the cash flows from mortgages such that some tranches were quite secure while others were quite risky. Guess which one Mr. Hayes got?) Did his account rep have any idea about the risk inherent in this investment? If the account rep did, he/she clearly violated his/her fiduciary duty to the client, as minimal due diligence (i.e., a call to the New York desk) would have uncovered the risk. Most likely, the account rep was blinded by the large ($37,000) fee associated with the sale of the tranche.
• As it turns out, the loans Merrill Lynch placed into the tranche had already fallen in value by 5 percent before the investment was sold to Mr. Hayes. The investment was worthless at inception. Worse, it looks like the folks at Merrill Lynch who issued the paper knew it.
• After more than five years, arbitrators awarded Mr. Hayes $218,000 in attorney fees. In addition, Hayes had to shell out $23,500 in other costs and was potentially liable for $8,400 in hearing fees.
• Hayes won the return of his investment, interest on it, attorney fees and the other costs, or about $1.38 million, because it was clear, even to the arbitrators, that the paper sold to him was worthless before it was purchased on his behalf and that Merrill Lynch most likely knew it. Yet despite the apparent fraud and Merrill Lynch’s shunning of its fiduciary duties to the client, no punitive damages were awarded. This speaks to the inherent bias against the investor and for the broker/dealer, which appears to permeate the system when it comes to Wall Street.
• It is interesting to note there were two such tranches, one for U.S. clients and another for foreign clients. Mr. Hayes purchased the entire U.S. tranche. The foreign investors, who purchased the other tranche, also sued and settled for an undisclosed amount. Of further interest in this case is that the Massachusetts Secretary of State has subpoenaed the same or similar records to see if Merrill Lynch knowingly overvalued assets it put into investment pools (“Galvin demands B of A records on mortgages,” www. BostonHerald.com on Feb. 11).
• Mr. Hayes’ attorney, Reno’s Thomas Bradley, has written about other inappropriate investments being foisted on unsuspecting small investors, usually because the commissions on the sales of such instruments are high (see http://blog. stockmarketattorney.com/many-investors- mislead-by-brokerage-firms-to- purchase-unlisted-reits.html).
From a lack of any real return to unconscionable fees and costs to an unaffordable and often unjust litigation process, the Wall Street system is rigged against the small investor. Just think of how many small investors were put into similar investments by Wall Street’s major broker/dealers. Few of them have the assets or stamina to fight Wall Street like Mr. Hayes did.
Most, if they actually do pursue legal action, settle for pennies on the dollar because of the costs, effort, and additional potential loss should the arbitrators rule against them.
Despite these abuses, the government continues to come to Wall Street’s aid. No one yet has gone to prison over the sub- prime fiasco. No one is likely to go to prison in the M.F. Global scam. Despite the obvious fraud, no punitive damages were assessed in the Hayes case.
U.S. households have $700 billion in negative equity in their homes, and the government (who had its own fingers in the mortgage fiasco) last week settled with the biggest perpetrators for 3.5 cents on the dollar. With only slaps on the wrist and minor fines or penalties for fraudulent behavior and the shirking of fiduciary obligations, what will incent Wall Street to alter its behavior?
Conclusion: Little is going to change for small investors in America unless and until the Wall Street playing field is leveled.
Robert Barone, Ph.D.

February 16, 2012

Debunking the Warren Buffett Tax Deception

Posted in Economy, Finance, government, investment advisor, investment banking, investments, IRS, local banks, taxes tagged , , , , , , , , , , , , , , , , , , , , , at 10:10 PM by Robert Barone

It is an election year, so the media makes a big deal out of Warren Buffett’s assertion that the tax system unfairly taxes his supposedly “working class” secretary at 33% (we’ve also seen 34% and 35.8%), while he only pays 13.7% (we’ve also seen 17.4%) on the millions that he makes.

The political implication is that he, and others like him, such as GOP hopeful Mitt Romney, somehow aren’t paying their “fair share” of taxes.

But instead of doing even superficial analysis, the media carries the story at face value. That is naive. Even a slight amount of digging will turn this story upside down.

Let’s start with Buffett’s secretary, Debbie Bosanek. In order to pay a marginal tax rate of 33% (or 34% or 35.8%), she would have to be in Occupy Wall Street’s 1%, not the 99%. Using the 2011 tax tables for individuals, if she were single making a $250,000 adjusted gross income (that’s after deductions!), she would be in the 33% marginal tax bracket and would have a 27% effective tax rate. To get to the 35% marginal tax bracket, her adjusted gross income would have to be more than $379,000. Isn’t a $250,000 income the magic line that [President Barack] Obama has drawn that demarcates those who he is targeting as “rich” and should be paying more taxes? So, let’s not be deluded into thinking that his woman somehow represents America’s working class.

But the bigger deception is Buffett’s claim that he pays a much lower tax rate than he supposedly should. A quick review of business taxation in the US today will show that Buffett pays in excess of 30% of his income in taxes.

Most small-business owners choose the Subchapter-S or LLC format for their businesses. Any profit from their business flows directly to their personal taxes (form 1040). Assume two similar businesses, one owned by X and the other by Y. Both businesses make $450,000 in pretax income. Owner X has chosen the LLC format. Owner X’s company pays no taxes to the IRS, but sends Owner X a K-1 requiring X to declare $450,000 on his form 1040. His marginal tax bracket is 35%.

Owner Y has chosen the C-Corp format. Y’s company also had a pretax income of $450,000, which is taxed at the corporate 35% tax rate. Y has chosen to declare a $50,000 dividend to himself which shows up on his 1040 and is taxed at 15%. Looking only at his 1040, you would think that Y doesn’t pay much in taxes. In fact, Y pays more taxes than X because the dividend is double taxed – that is why most small businesses choose the LLC or Sub-S format.

Now let’s talk about Buffett. He is famous for buying large stakes or even controlling interests in large C-Corps. He is the equivalent to Owner Y.   So, the taxes that Buffett pays go well beyond what is shown on his 1040. Like Owner Y, the 13.7% rate on Buffett’s 1040 shows only the taxes he pays on the dividends and therefore is only part of the story. I looked up Buffett’s 13F SEC filing dated January 30, 2011. That filing shows nine major holdings.

Using the share price of each holding and the number of shares shown on the 13F, I estimated the value of each of those holdings. Then, using the C-Corp’s reported effective tax rate, the pretax income per share, and the dividends per share (taxed at 15%), I calculated Buffett’s effective tax rate on each holding. Finally, using the market value of each holding to form a weighted average, I then calculated that Buffett’s effective tax rate on these nine holdings was more than 32%.

Buffett Holdings from September 30, 2011 13F
Click to enlarge

This should debunk the myth that America’s investor class does not pay its “fair share” and that we should put a minimum of 30% on their 1040 filings.

Finally, some advice for Romney. Should you become the GOP candidate, I would advise that you do an analysis on your income similar to what I did for Buffett in the table above. If you are the GOP candidate, you can take the issue of paying your “fair share” of taxes off of the table.

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