August 19, 2011

The Mortgage Market – An Impediment to Economic Growth

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:54 PM by Robert Barone

The lack of clarity surrounding U.S. and worldwide economic growth certainly played a big role in the recent Wall Street sell off.  In part, it was precipitated by the “debt ceiling” prank that was played upon the country and the world, especially after the market dissected the deal and found that, through the use of smoke and mirrors, economic growth (and therefore tax revenues) was assumed to be 4%, a growth rate that is hard to fathom, at least for the U.S. and Europe, given the financial landscapes in these two major consuming regions.

Housing & GDP

Housing is a case in point.  The direct contribution of Residential Fixed Investment to GDP was 4.8% in 1990, 5.2% in 2000, and 6.1% during the housing boom of 2005.  In this year’s first half, it registered 2.2%, the lowest level since records have been kept.  This measure of housing’s impact on GDP significantly understates its importance.  Ancillary to housing are such things as furniture and furnishings, appliances, demand for utilities, demand for other services such as landscape and repair, etc.  Then there is the multiplier impact of the earnings of construction workers as they spend those incomes in the course of everyday living.  It can be said with a high degree of certainty that U.S. economic growth will be weak until housing returns to some semblance of health.  Historically, changes in housing construction have contributed significantly to the business cycle, both to pushing the economy into recession, and to lifting it out.   In most post-WWII recessions, a housing turnaround usually starts before the recession ends.  Given the state of housing today, is it any wonder why the U.S. economy is at stall speed?

The Swinging Pendulum

In 2005 and 2006, if you could breathe, you could get a mortgage loan with little or nothing down and just your word on whether or not you could afford the payments.  But today, just when the economy needs a growing housing sector, the pendulum has swung to the other extreme.  Not only have most mortgage companies disappeared, but the criteria to qualify for those that are still in business are the strictest they have ever been.  In addition, Congress and the states have now placed many obstacles into the mortgage lenders’ paths including the promotion of legal actions against the largest mortgage lenders (or their successors) and the provision of legal aid, in the form of obstacles to the foreclosure process, to underwater homeowners who have quit making payments.

  • Bank of America (BAC) has tried to extract themselves from the litigation cesspool resulting from their acquisition of Countrywide with an $8.5 billion global settlement, which still has to be approved by the court. (Just think – BAC purchased this garbage heap without any government assistance – does this say something about BAC management?)  But, NY State’s Attorney General has decided that $8.5 billion is completely inadequate, indicating that the settlement should be in the $22 to $27.5 billion range.  At the same time, AIG is planning to sue BAC for $10 billion on the grounds that the mortgages it purchased from Countrywide were misrepresented (whatever happened to due diligence or buyer beware, especially for “sophisticated” investors?).
  • With all this going on, it isn’t any wonder that Jamie Dimon has decided to remove JPMorganChase (JPM) entirely from the mortgage business.  Dimon has proven over the years that he is an industry leader, so, his withdrawal from the mortgage business may be an omen of things to come.
  • Meanwhile, states are passing legislation aimed at “helping” consumers, but with vast unintended consequences for the mortgage markets.  Don’t misunderstand – I am not arguing in favor of the mega banks and Wall Street who have significant responsibility for the current state of housing in the U.S.  But, litigation and legislation could have the unintended consequence of further slowing and postponing any housing rebound:
  • According to Mark Hanson of M Hanson Research, California recently passed legislation prohibiting second lien holders from filing deficiency judgments in short sales.  Immediately JPM pulled all of their short sale second lien buyout acceptances, which forgive significant second lien deficiencies for a price of $3,000 to $5,000, and is now asking for 50% of the note amount.  This will nullify the short sale and force the first lienholder to foreclose, now giving JPM the right to a deficiency judgment.  Such legislation may have an adverse and unintended consequence of scuttling the short sale market in California, just when real progress was being made.
  • Nevada leads the nation in underwater mortgages.  Zillow reports those numbers are as high as 80% in Las Vegas and 70% in Reno.  To deal with this, the last Nevada legislature passed legislation which prohibits a first lienholder from collecting a deficiency judgment on a primary residence short sale.  This means that everyone underwater can walk away without significant consequences and presages even more short sales and foreclosures.  In addition, another law prohibits note holders who purchased mortgage notes at a discount from collecting more than they paid for the note in a foreclosure process.  The consequences of such interference can potentially be disastrous for the secondary mortgage market.  Taken to its logical conclusion, no one would be willing to purchase troubled loans at a discount because the best return possible is just a return of capital.

Bank Capital

Another drag on the mortgage market, and, in fact on the market for all non-government guaranteed private sector loans, is the push on the part of regulators to drive bank capital levels higher.  Too much leverage along with the repeal of Glass-Steagall certainly played a large role in the global financial crisis, whose second act is currently on stage in Europe.  Bank capital and liquidity ratios are now under close scrutiny, and the Basle III accords will require banks to hold significantly more capital and in purer form.  To “preserve” their capital and meet the stricter requirements, banks will prefer to invest in items exempt from the capital requirements (like government guaranteed paper) rather than placing assets in areas requiring high capital retention.  (The spenders in Washington appear to be quite comfortable with this!)  The unintended consequence here will be fewer “risky” loans, and those that are made will be at much higher interest rates to compensate for the additional capital required.

Qualified Residential Mortgage (QRM) and Qualified Mortgage (QM)

The Dodd-Frank legislation is also in the process of imposing significant restrictions on mortgage lenders.  One Washington lawyer, Laurence Platt, recently remarked that “the natural consequence of QM and QRM is that only the most privileged borrowers in our country will be able to get mortgage loans…”

QRM requires lenders to meet strict underwriting standards, which will be written into Fannie Mae and Freddie Mac guidelines.  Failing that, the lender must retain 5% of the credit risk if the loan is sold or securitized.  QRM requires a minimum 20% down payment and very low debt to income ratios.  The FDIC has indicated that approximately $8.5 trillion of currently outstanding mortgage loans would not have qualified under these guidelines.  Lenders have testified that any non-QRM loan would be very expensive for consumers.

More scary is the QM standard which prohibits such things as negative amortization loans, loans with balloon payments, or loans with terms exceeding 30 years.  But the kicker to QM, as proposed, is that there are severe legal and monetary penalties to lenders if it is determined that the borrower did not have the “ability to repay” at the time the loan was originated.  Even “unintentional” violations can be fined at $5,000/day.  Imagine what the legal profession is going to do to this “ability to pay” standard.  I suspect that the fact that the home went into foreclosure will be a strike against the lender under QM.

Clearly, both the QM and QRM compliance nightmares discourage the reappearance of the small mortgage companies that dotted our landscape just a short 5 years ago.  Only the large institutions can afford the compliance here, and, as discussed above, they have other significant impediments to being in the mortgage business.

Fannie and Freddie Cutbacks

The bankrupt Fannie Mae and Freddie Mac, which currently purchase more than 90% of mortgages made today, are significantly reducing their loan maximums effective October 1.  This can’t be anything but negative for the mortgage markets.  As these two behemoths continue to cost taxpayers billions of dollars every month, sooner or later (certainly not until after the 2012 elections) their losses will have to be addressed.  Fannie and Freddie alone, in the current environment, cannot support a growing mortgage market with reasonably priced mortgages, a requirement for the U.S. economy to prosper.

Where are the Cash Down Payments?

According to Zillow, 26% of mortgages in the U.S. are underwater with some markets significantly higher.  Mark Hanson has made the point several times that when short sales or foreclosures occur, the former homeowner generally has no cash or resources to use as a down payment on another home.  (No wonder apartment REITs are booming!)  This alone culls the pool of potential home buyers.

Conclusion

In the end, the impediments to the mortgage market appear significant: litigation, new consumer “friendly” legislation, higher bank capital requirements, QM and QRM compliance issues, and lower maximum loan amounts from the bankrupt Fannie Mae and Freddie Mac entities are all coming together at once.  The reduction of the availability of mortgage money is a certainty.  In addition, a large swath of consumers with underwater mortgages and those with excessive credit debt burdens simply have no funds for the down payments that will now be required under the Dodd-Frank legislation.  Under such conditions, it is likely that home prices will continue their downward spiral and new home construction will continue at record low levels.

As stated at the beginning of this piece, housing has historically led the economy out of recessions.  Not this time!  Without a healthy housing sector, economic growth is significantly constrained.  Under these circumstances, the idea of 4%, or even 3%, economic growth reappearing in the U.S. anytime soon is a dream only Washington politicians can harbor.  The reality is that without a healthy housing sector, even 2% long term growth seems like a stretch, and the economy will remain vulnerable to outside shocks.

Robert Barone, Ph.D.

August 15, 2011

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

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).   A copy of the Brochure may be obtained by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778

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July 13, 2011

Gold – Is it a Bubble?

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:23 PM by Robert Barone

Is the price of gold too high?  Too low?  Is it in bubble territory, ready to drop rapidly?  Think about what bubbles are – you know there is a bubble when everyone is trying to participate.  For example, during the dot.com bubble, my tennis pro was buying and selling options several times per day!  I knew we were in a bubble.  I even told him so.  And, during the housing bubble, all of the chatter at cocktail parties was about flipping houses as a side business.  I knew we were in a bubble (just didn’t know how frothy it really was!)  People say to me all of the time when I talk about gold: “I would love to own gold, but its price is just too high.”  Hmm!  Too high relative to what?

The price of gold certainly can be fickle.  After all, unlike other commodities that are essential inputs into some vital process (e.g. the production of energy or food), besides some very minor industrial applications, gold really has few practical uses (jewelry and art excepted).  There is nothing intrinsic in gold to give it value.  There is no cash dividend or earnings.  It goes up and down in value at the whims of investor demand.

Gold does have three characteristics that make it unique: 1) it is rare and hard to find (all the world’s gold is estimated to fit into two Olympic sized swimming pools); 2) it doesn’t change form – all of the gold ever mined is still with us as gold; 3) it cannot be “produced” via the combination of other materials.  Thus, its supply is well defined and increases very slowly and at great expense.  Thus, it is perfect as a medium of exchange or a store of value.

We all know what makes the demand for gold go up – distrust in fiat currencies, and government deficits resulting in paper money printing.  And that, of course, is why gold is rising in value today.  As long as that goes on, the price of gold will keep on rising. So, what could happen to make it fall in value?  I have listed several things below which could happen – I will let you be the judge of their likelihood:

  • The U.S. and the rest of the developed world (Europe) stop running fiscal deficits and stop printing money.  There is an immediate opportunity for this to begin in the U.S. if the GOP and Obama Administration can agree on significant spending cutbacks.  This means entitlement reform.
  • The U.S. economy magically finds its feet and its growth rate increases such that the unemployment rate begins to rapidly fall without additional monetary or fiscal stimulus.  Interest rates would be rising too.
  • As a subset of the above, housing prices find their bottom and begin to rise with home sales and new home construction picking up.
  • The dollar reverses is slide as the premier world reserve currency and becomes demanded because of its intrinsic strength, not just because it is better than all of the other bad alternative currencies (e.g., the Euro). (This requires fiscal and monetary discipline and a reduction in both public and private debt loads.)

As long as gold is viewed as the ultimate monetary unit, its value will increase (decrease) with the debasement (strength) of the fiat currencies.

Robert Barone, Ph.D.

July 13, 2011

Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, a SEC Registered Investment Advisor.The mention of gold, commodities, or similar investments in this article should not be considered a recommendation to sell or purchase any commodity or similar investments mentioned.  Please consult an investment professional on how the purchase or sale of such investments can be implemented to meet your particular investment objective or goals.   Investments in gold, commodities, and/or similar investments are subject to risks.  It is important to obtain information about and understand these risks prior to investing.

 

July 12, 2011

Italian Contagion

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:17 PM by Robert Barone

Just a couple of weeks ago, with the supposed “solution” to the Greek crisis, many market participants thought that the politicians had bought at least several months of relief from the European debt crisis.  But, just as the markets attacked the stocks of both Morgan Stanley and Goldman Sachs after the failure of Lehman, it should have been expected that the markets would go for the European Monetary Union’s (EMU) jugular, Italy.  And, it didn’t take long.

Too Big To Bail

Logically, Italy’s debt was always going to be the issue that determined the EMU’s fate.  That is because Italy’s sovereign debt outstanding is over €1.6 trillion (compared to €345 billion for Greece, and €150 billion for both Portugal and Ireland), its debt/GDP ratio is a punishing 120%, and its estimated annual funding needs will run at roughly €250 billion.  That annual funding need is larger than the other European PIGS (Portugal, Ireland, Greece and Spain) combined.  Because the remaining capacity of the ESFS (European Financial Stability Facility) is just €320 billion, it is not big enough to finance Italy’s borrowing needs for more than a year, much less deal with Ireland, Portugal and Spain.  Thus, Noruma Securities had dubbed Italy as “Too Big to Bail” (TBTB).  In the end, it would be up to Germany and France, the two biggest economic powers in the EMU, to save Italy, the third biggest economy.  That would require a commitment of more than €500 billion, or about 10% of their combined economies, a figure that is probably not politically doable.

Nonchalance

While there appears to be some concern in the financial markets about the European debt issues, the markets appear nonchalant about it.  The “contagion” so far appears to be limited to some of Europe’s banks and to the markets for PIIGS debt (Portugal, Ireland, Italy, Greece and Spain).   For example, the VIX for U.S. equities is barely off its lows.  Our belief is that this situation is much more serious than embodied in the current market reaction, and the “contagion” could easily spread worldwide:

  • A selloff in Italian bonds could put pressure on the Italian banking system (which holds 6.33% of Italy’s sovereign debt according to JPMorganChase), which could lead to fears of insolvency.  This, in turn could lead to bank runs and perhaps some failures.  But it surely would require government intervention (perhaps nationalization) and capital raises (if possible);
  • Any resulting bank bailouts would add more debt to an overburdened Europe, thus exacerbating an already critical debt situation;
  • But, the most dangerous “contagion” is most likely in the Credit Default Swap (CDS) arena which is extremely difficult to quantify because it remains unregulated.  As with Greece, any default runs the risk of triggering CDS payments.  And, it is not known if the CDS counterparties have sufficient capital to pay in the event of a default by Greece, much less Italy.  For all we know, there may be another AIG out there, or perhaps a CDS event may fatally wound a large systemic worldwide financial institution.

Our view is that this situation is much more dangerous than the markets have priced in.

Robert Barone, Ph.D.

Matt Marcewicz

July 12, 2011

Robert Barone is a Principal and an Investment Advisor Representative, and Matt Marcewicz is an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, a SEC Registered Investment Advisor.Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

The mention of foreign currencies and foreign investments or similar investments in this article should not be considered recommendation to sell or purchase any security or similar investments mentioned.  An investment in the currencies and securities of foreign countries may be deemed to be speculative in nature.  Investments are subject to various investment, trading and foreign exchange risks including the risk of possible loss of principal.  It is important to obtain information about and understand these risks prior to investing. Consult an investment professional on how the purchase or sale of such investments may be implemented to meet your particular investment objective or goals.

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: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

 

July 11, 2011

What’s Next for the Fed: Rock ‘N Roll!

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:11 PM by Robert Barone

On July 8, immediately after the dismal employment report, this is what the Wall Street Journal had to say:

After spending funds to fight the crisis, policy makers have few tools left to stimulate the economy.  Mr. Obama is focused on cutting the budget deficit, while the Federal Reserve, which sees unemployment at about 8.0% at the end of 2012, has already cut interest rates close to zero and is reluctant to purchase more government bonds now that inflation is rising. (Luca DiLeo, “Jobs Data Dim Recovery Hopes”)

In addition, in the last week of June, the U.S. 10 year Treasury Note’s interest cost rose 29 basis points from 2.91% (June 23rd) to 3.20% (July 1st).   At this writing, we cannot be sure if this move was in response to 1) the “temporary” respite of the Greek debt drama and a reversal of “flight to safety” trades, 2) a noticeable reduction in foreign demand for U.S. debt during the Treasury auctions of the week of June 27th, or 3) a combination of the two.  Indeed, during the June 27th week, QE2 was still active, so what happened to interest rates could just be a prelude of what will happen without additional Fed intervention.

In their 2010 working paper, “The future of public debt: prospects and implications” (Bank of International Settlements, March, 2010), authors Cecchetti, Mohanty and Zampoli conclude that since “Most of the projected deficits [for the world’s industrial economies] are structural rather than cyclical in nature … we can expect these deficits to persist even during the cyclical recovery”.  They ask: “When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways?”  They conclude that it is a question of “when”, not “if” markets put pressure on the cost of such debt, causing interest rates to rise.  Enter the Fed.

We saw the Fed liquefy the world in ’09 including non-member foreign banks over which they have little influence or authority.  And now we have learned that they secretly loaned huge amounts to the primary dealers in the aftermath of the financial crisis.  Then we saw them intervene again with the late August, 2010 announcement and subsequent June, 2011 completion of QE2.  During the latter intervention, the Fed essentially monetized much of the U.S. budget deficit.

Given the fact that the presidential election cycle has already begun, we strongly suspect that the weakening economy and upward pressure on interest rates due to oversupply will cause further Fed intervention, even if it isn’t called QE3.  At his post-Federal Open Market Committee (FOMC) press briefing, Bernanke indicated that if job growth falls below 80,000 per month, the Fed would likely intervene again.  (Job growth has now been below 80,000 for two consecutive months!)  So, “when” it comes (not “if”), what sort of intervention can we expect?

A look back at then Fed Governor Bernanke’s November 21, 2002 talk before the National Economists Club of Washington, D.C. entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here”, gives us some clues.  In that talk, he ostensibly outlined all of the tools available to the Fed if the overnight (Fed Funds) rate hit zero.  After all, at the time of the speech, deflation wasn’t expected in the foreseeable future, so he would have no reason not to outline all the tools he could think of.  I have outlined them below:

  • #1: Expand the scale of asset purchases;
  • #2: Expand the menu of assets the Fed buys.

Both QE1 and QE2 used these tools.  In QE1, the Fed purchased non-traditional assets for its portfolio, including mortgage backed securities (MBS) and derivatives.  In both QE1 and QE2, the “scale” of asset purchases was dramatically increased.

  • #3: A commitment to holding the overnight rate at zero for some specified period.

This tool is currently in practice with the Fed’s “extended period” language in the Federal Open Market Committee (FOMC) minutes.

  • #4: Announcement of explicit ceilings on longer-maturity Treasury debt.

This isn’t new.  The Fed did this in the 1940s and a version of it again in the 1960s.  During a period of approximately 10 years ending with the Federal Reserve-Treasury Accord of 1951, the Fed “pegged” the long-term Treasury bond yield at 2.5%.  And, during the Kennedy Administration, the Fed sold T-bills and purchased an equal amount of longer dated T-Notes in order to reduce long-term rates.   Bernanke believes that the announced policy of pegging will cause arbitrageurs to keep yields near the announced peg, especially if the Fed intervenes several times to prove its commitment.

  • #5: Directly influencing the yields on privately issued securities.

“If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”  Think GM, Chrysler, AIG.

  • #6: Purchase foreign government debt.

The Fed would do this, Bernanke explains, to influence the market for foreign exchange, i.e., to weaken the dollar.  He points to the dollar devaluation of 1933-34 as an “effective weapon against deflation”.  “The devaluation and the rapid increase in the money supply it permitted ended the U.S. deflation remarkably quickly … The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market.”  (While this is true, a mere two years later, after the withdrawal of government stimulus, a second severe recession began,  one that would last until the U.S. geared up for World War II.  And the 1937 slump in stocks was one of the largest on record.)

  • #7: Tax cuts accommodated by a program of open market purchases.

“A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money”, he said in the speech.  (Hence his nickname – Helicopter Ben.)  The extension of the Bush tax cuts along with the reduction in the social security payroll tax is a recent example of this policy.

These 7 tools are non-traditional, and Bernanke admits that by using them, the Fed “will be operating in less familiar territory” and will “introduce uncertainty in the size and timing of the economy’s response to policy actions”.  Nevertheless, he says, “a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition … A central bank … retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is zero”.  Today, any objective economist will tell you that, despite all of the monetary and fiscal stimulus, aggregate demand and economic activity has been minimally impacted.  At the July post-FOMC press briefing, Bernanke admitted that he has no explanation as to why the economy has remained “soft”.  Nevertheless, as stated above, in an election cycle, the Fed would be expected to do “something”.

Of the 7 available tools, #1 appears to have been taken off the table, and #3 is presently employed.  Tools #5 and #7 have been used, and may be employed again.  #5 was heavily used in the financial crisis (GM, Chrysler, AIG), and #7 requires the cooperation of Congress (tax cuts).  The Fed said that it won’t reduce the size of its balance sheet in the near future, holding it steady like a rock, but will invest or roll any maturities or payoffs back into the market.  Hence, the Fed has already embarked upon a policy of what we will call Rock ‘N Roll.  As part of Rock ‘N Roll, we also expect the Fed to change the composition of its balance sheet to attempt to impact yields on private sector bonds (#5).

Conclusion

Over the past 2 years, Fed actions appear to have had little impact on aggregate demand.  In 2002, when he outlined these non-traditional tools, Bernanke said he had no idea of the magnitude of their effectiveness.  Today, however, we have a couple of years of historical data on which to judge.  Eric Swanson, an economist at the Fed of San Francisco, in a March, 2011 paper entitled “Let’s Twist Again: A High-Frequency Event-Study Analysis of Operation Twist and Its Implications for QE2” concluded that the impact of QE2 on the Treasury yield curve was a statistically significant, but moderate 15 basis points.  (That’s not much for $600 billion!)  In addition, Swanson says that the effects “diminish substantially as one moves away from Treasury securities and toward private credit instruments”.

Thus, despite their demonstrated impotence, we expect that the Fed will use tools #4 and #5 in an effort to lower longer-term Treasury rates and simultaneously attempt to reduce private sector rates.  The success of such moves is much in doubt, especially if their balance sheet is constrained.   Tool #6, and other policies to weaken the dollar, however, will continue to be the primary and most effective thrust of Fed policy.  That means inflation will continue to be fostered.

Robert Barone, Ph.D.

Joshua Barone

July 11, 2011

Robert Barone and Joshua Barone are Principals and an Investment Advisor Representatives of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

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: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

 

June 29, 2011

Job Creation: Why There’s None; What Should be Done

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:46 PM by Robert Barone

It is clear to everyone that the economic vitality of the U.S. is based on jobs.  Since its peak in late ’07, the U.S. has lost between 6.8 and 7.0 million jobs (depending on which employment survey you consult).  Despite record deficits, spending, various stimulus schemes, and money printing programs, jobs are not being created at a pace that results in a falling unemployment rate.  And, there is a lot of evidenced that the official unemployment rate (the U3 series) seriously understates the issue.  In his latest press conference, as QE2 is about to end, Fed Chairman Bernanke appears to be befuddled as to why the U.S. economy is softening.  The Obama Administration’s release of 30 million barrels of oil from the Strategic Petroleum Reserve (just over one day’s usage) with prices already retreating certainly appears to have an element of desperation in it, aimed, perhaps, at the 2012 election.  For sure, after trying everything in the Keynesian playbook, no one with any policymaking power seems to have a clue about how jobs get created.

The Problem: Deteriorating Balance Sheets

Demand, of course, is the key.  If demand rises, employment will eventually follow.  And it is not corporate America that is in need, as they stand around with record levels of cash looking for something to do with it.  But, middle America, the heart of the consumption machine, is in trouble.  We know that real wages have been stagnant since the late ‘90s and that the economic boom of the early part of the last decade was induced by debt and artificially low interest rates.  But, besides stagnant wages, the biggest issue for Americans is their deteriorating balance sheets.  Since the largest item in their asset base is their home, the relentless downward march of property values is simply debilitating to the net worth of a significant percentage of Americans, and this is likely the most significant factor in the stagnation of consumption despite the record level of stimulus.  As an aside, the Fed’s QE2 program did raise the level of equity prices, but only a small segment of America benefitted.  So, we’ve recently seen a rise in luxury retail sales, but little else.  If we leave things as they are (unlikely in an approaching election year), because of the binge of Alt-A mortgage lending in ’06, 2011 is seeing the beginnings of another wave of defaults.  Five years is the magic number written into those mortgage notes.  At the end of five years, principle payments begin.  For a property already underwater, a doubling of the monthly payment simply induces default.  So, if nothing changes, the U.S. has at least 18 more months of high foreclosure activity and declining property values.

Pent-Up Demand

Looking back at the employment data, in mid-’06, there were 7.7 million construction workers.  Today, there are 5.5 million.  Doing the math, of the 7 million lost jobs from the ’07 peak, 2.2 million (31%) are in construction.  The fact is, U.S. periods of economic expansion have always been accompanied by high employment in the construction trades.  In addition, there is a multiplier effect both when jobs are created or lost as jobs in other ancillary industries (like home furnishings) are positively or negatively impacted to say nothing of jobs created simply as support (services etc.).  After four years of the lowest level of construction activity on record, a level we know is below replacement and certainly below the needs of a rising population, with families moving in together and college graduates remaining in their parents’ homes, there has to be a huge pent-up demand for housing.  But, no one will buy while prices are falling, and prices will continue to fall while foreclosures remain near record levels. One key to job creation, then, is stable or rising home values.  That would result in rising sales and would stimulate construction employment with its attendant job multiplier.

Extend and Pretend

Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff have completed several studies examining the aftermath of balance sheet recessions.  In a recent interview with Investors Business Daily (“Slow Growth Normal For Post Fin’l Crisis Recoveries”, Norm Alster, 5/23/11), Vincent Reinhart said that in Japan, for example, “the banks were allowed to carry bad assets on their books at inflated values”.  As a result, “property prices have declined for 20 years”.  Reinhart concludes that “the government’s willingness to let banks carry bad debt rather than force them to take losses tends to stretch out the process of deleveraging.  When you let banks carry their assets at high values relative to their market values, it freezes that market”.  His prescription: “Recognize the losses … take the hit”.

We have a 20+ year example with Japan, 3+ years in the U.S., and now, Europe is about to embark on a similar path with the “extend and pretend” game with Greek debt.

Prescription

Here is a 4 step prescription to stop the downward spiral in home prices, renew consumer confidence, increase consumption, and create jobs, all without additional spending.

  1. All real estate notes held by Financial Institutions (“FI’s”) must be written down to appraised values (i.e., marked to market).  Much of this has already taken place as regulators have examined the books of the FIs.  Pools of mortgages trading in the secondary market have had their prices adjust to the reality of the market place.  The larger FIs have already raised capital.  To some extent, the plethora of short sales in which the FIs do not require deficiency payments is occurring because the assets have already been written down and the FI has already taken the hit.
  2. The asset write-downs have been causing failures among those smaller FIs that have no access to the capital markets.  This is costing the taxpayers in the form of fewer choices, and since the FDIC fund has been depleted and assessments on FIs have risen, consumers are paying higher prices for their financial services.  The following was tried in the ‘90s during the S&L crisis, and mostly worked, failing only when government reneged.  I am talking about the establishment of a special regulatory asset category into which the losses from the asset write-downs are placed.  Such an asset (think of it as similar to goodwill) can be amortized over a fairly long period, say 10 or 15 years.  Thus, from a regulatory perspective, the capital of the institution is not depleted immediately.  Because liquidity is the most important part of an FI, GAAP insolvent institutions can operate and remain open indefinitely.  We saw this in the 80s in the S&L debacle, and it is true today for many FIs (including, perhaps some in the SIFI {“Systemically Important financial Institutions”} category, and definitely some large European institutions) that don’t recognize the true value of their assets.  Under this scenario, no taxpayer funds are expended. (Such a scenario can also play well with the SIFIs which are being pressured to have higher levels of capital since they pose systemic risks.)
  3. With assets written down, in order to qualify for the special regulatory asset category, FIs must now reduce the balances owed by the mortgagors to appraised value and offer the residential borrower a 30 year fixed rate or a 5/1 ARM (borrower’s choice) at market rates. (Congress must also extend the provision that such debt forgiveness is not a taxable event.) I can even postulate a scenario in which the borrowers must share in any “profits” with the FI if the property sells for more than the written down mortgage note value.  Some financial institutions, like JPMorganChase (“JPM”), have already done such note reductions with some of the loans they “bought” from Washington Mutual (“WaMu”) when they “purchased” WaMu in an FDIC assisted sale.  [Having bought these assets at pennies on the dollar, accounting rules will not let them write the assets “up” to their true market values.  So, last year, JPM reduced the mortgage notes to the borrower on some of the WaMu assets to an estimated market value still above the book value, while, at the same time, raising the interest rate.  A win-win.  The note holder could now sell the home at market value, and, if they didn’t, JPM got an enhanced interest return on the asset.  Once sold, JPM gets to write-up the asset from its book value to the reduced mortgage note value.]  The result of such a program would be a rapid fall in foreclosure activity.  Properties could be sold without a short sale.  Without foreclosure activity, prices would stabilize, even rise.  With their balance sheets now stable to rising, consumers and small businesses would have more confidence, and the pent-up demand for homes and other properties would appear.  New construction would occur.  JOBS would be CREATED.
  4. One more missing piece.  When a home with an underwater mortgage note sells for appraised value, the selling homeowner has no equity with which to purchase another home, even with a good job, good credit scores, and acceptable expense ratios.  In a recent article (Barron’s “The Next Mortgage Bombshell”, 6/25/11) author Jonathan Laing indicates that the big three private mortgage insurers, PMI, Radian, and MGIC, likely have insufficient capital to survive the current housing depression.  Enter FNMA (“Fannie”), FHLMC (“Freddie”) or their successor(s).  The original concept of Fannie and Freddie was to provide liquidity to the mortgage market, not to become the dominating forces.  Becoming mortgage insurers would accomplish the original intent.  And no taxpayer dollars would have to be expended if the mortgage insurance is properly underwritten.  By insuring the top 10%-20% of new mortgages, those underwater homeowners who sell are now able to repurchase, and FIs can issue new loans with a 10%-20% equity cushion, just like in the old days.

Almost none of this is new.  In the search for solutions to the jobs issue, at least this attacks the problem – the deterioration of middle America’s balance sheet.  And it won’t cost the taxpayer a single dollar.

 

Robert Barone, Ph.D.

June 27, 2011

Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.  He is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).

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

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778

 

June 27, 2011

Bernanke: Failure, or Just Delusional?

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:47 PM by Robert Barone

In his June 7th speech, Fed Chairman Ben Bernanke stated, “the best way for the Federal Reserve to support the fundamental value of the dollar in the medium term is to pursue our dual mandate of maximum employment and price stability, and we will certainly do that.“.

It is instructive to take a look at the actual Federal Reserve goals, as well Bernanke’s results in pursuing those goals.

Goals of Monetary Policy (emphasis added)

“The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Mar­ket Committee should seek ‘to promote effectively the goals of maxi­mum employment, stable prices, and moderate long-term interest rates’.  Stable prices in the long run are a precondition for maximum sustainable output growth and employment as well as moderate long-term interest rates. When prices are stable and believed likely to remain so, the prices of goods, services, materials, and labor are undistorted by inflation and serve as clearer signals and guides to the efficient allocation of resources and thus contribute to higher standards of living. Moreover, stable prices foster saving and capital formation, because when the risk of erosion of asset values resulting from inflation—and the need to guard against such losses—are minimized, households are encouraged to save more and busi­nesses are encouraged to invest more.” (http://www.federalreserve.gov/pf/pdf/pf_2.pdf)

Let’s look at the results of Bernanke’s economic “fine tuning”(using data from the St. Louis Fed’s database, starting in February, 2006, through April 2011), and see if he has successfully pursued this mandate.

Definition of STABLE (from the Mirriam-Webster dictionary)

a : firmly established : fixed, steadfast <stable opinions>

b : not changing or fluctuating : unvarying <in stable condition>

c : permanent, enduring <stable civilizations>

Stable Prices?

Stable prices are one of the Fed’s primary mandates.  In the table below, take a look at what has happened to the prices of items in a typical U.S. consumer’s budget since Ben took the reins:

Feb ’06 – April ’11

Items in a Typical Budget

% Change

Food and Beverages

16.54%

Water and sewer and trash collection services

31.88%

Rent of primary residence

13.82%

 Housing

8.68%

Fuels and Utilities

11.93%

Apparel

4.83%

 Medical Care

20.11%

Gasoline (all types)

65.12%

Transportation

23.36%

Tuition, other school fees, and childcare

29.28%

Recreation

2.87%

It is easy to play with the weightings of the above prices, and see how individual budgets would be impacted.  Regardless of the method used to look at prices, it is clear that Bernanke has not been successful at maintaining price stability since taking over as Fed Chairman.  Mandate not accomplished.

Maximum or Full Employment

Finding a strict definition of maximum employment is impossible.  Many economist give different estimates, ranging from 2-7%.  The standard Unemployment Rate most often used by the Fed is currently at 9.1%, up 90% since Bernanke started.  The more inclusive (realistic) U6 number stands at 15.8%, up 75% in the same period.  The Civilian Participation Rate has declined 2.87% to 64.2%.  This is the lowest level the U.S. has seen since March, 1984.  The decline amounts to 8,946,844 fewer Americans in the labor force.  Had they not dropped out because of a lack of jobs, the “official” unemployment rate would be significantly higher.  While we can debate the meaning of the term maximum employment, it is clear that the jobs data has deteriorated considerably since Bernanke took the reins at the Fed.  Mandate not accomplished.

Moderate Interest Rates

While not stated in Bernanke’s recent address, the Fed’s website also posts “moderate interest rates” as a stated goal.  While we cannot definitively say what constitutes “moderate”, we do know that both short and long-term interest rates are near all time lows.  It is safe to assume that near record low rates are not “moderate”.  Further, when  interest rates are artificially held below the rate of economic growth,” financial repression” is occurring.  Many bright folks have commented on how the zero interest rate policy (ZIRP) is destructive to savers and misallocates resources.  It is safe to say that this mandate has not been accomplished.

In conclusion, it is evident that Ben Bernanke is failing his mandates.  We believe it must come down to one of the following reasons:

  1. Bernanke does not know how to achieve his mandates;
  2. The policy tools employed don’t work;
  3. He does not have the ability to implement policies that would work;
  4. He is not trying to achieve his mandates;
  5. He has goals other than his legal mandates;
  6. He does not look at the data, and believes he is succeeding.

We will leave it up to our readers to make their own conclusions.

Matt Marcewicz

Robert Barone, Ph.D.

June 17, 2011

Matthew Marcewicz is an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.  He is also a Registered Representative of Ancora Securities, Inc. (Member FINRA/SIPC).  Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.  He is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

 

June 24, 2011

Two Soft Patch Views

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 4:38 PM by Robert Barone

There are two views on the softening economic data that began in April and has continued unabated.  The majority view is that the U.S. (and world) is in a “soft patch”, similar to the one that occurred last summer.  The disasters in Japan have caused supply chain disruptions which are blamed, along with $4/gallon gasoline, for the economic slowdown.  The view is, now that the supply disruptions are ending and gasoline prices are on the decline, consumption will expand thus ending the soft patch.

The minority view, and the one that I espouse, sees howling headwinds which threaten to turn the soft patch into outright recession.  What follows is a discussion of those headwinds.

  1. Employment is one of the two biggest issues facing the U.S. today even if one believes that the 9.1% unemployment number is accurate.  The headline Establishment Survey data is beset with issues from unstable seasonal factors to significant upward bias from an arcane birth-death business formation model which automatically adds approximately 50,000 jobs per month, as the Bureau of Labor Statistics believes that there are significantly more small businesses being created than are being closed.  Apparently, these folks haven’t left the Washington, D.C. area for the last couple of years. (See the work of John Williams at Shadow Government Statistics.)  It is more likely that the U6 unemployment rate (15.8%) is closer to reality.  The recent fall we have seen in the “official” rate from 9.8% in November to 9.1% in May appears to be more due to a falloff in layoffs than a rise in hiring.  Over taxation and over regulation are often cited as reasons businesses won’t hire, and I suspect this is partly true.  But, it appears that lack of demand and credit availability are the bigger culprits.  Data show that real wages have been flat to down since 1997, and that the expansion of ’02-’08 was based on debt alone, a condition that won’t occur again anytime soon.
  2. The other big issue in America today is mortgages.  More than 28% of them are underwater in the U.S.  On top of that, in ’06 at the height of the housing insanity, financial institutions were issuing 100%+ loans with negative amortizations for the first 5 years at variable interest rates.  Today, 5 years later, many such loans must begin full amortization, more than doubling the mortgage payments.  The vast majority of these will default.  Thus, we have at least 18 more months of significant foreclosure activity, falling home prices, and, as a result, continued low levels of new construction activity which used to be a significant economic driver.  The continued downward pressure on home prices will weigh heavily on consumer sentiment, consumer balance sheets, and consumption levels.
  3. According to David Rosenberg (Gluskin-Sheff), while QE2 certainly caused equity prices to rise, the wealth created in the past 8 months in the equity markets benefitted those least impacted by the slow economy, while the ongoing losses in home values hit middle America and the ordinary consumer much harder.  Without the payroll tax decrease at the beginning of the year, Rosenberg asserts that consumption would have declined in the first quarter.
  4. There are several news stories daily regarding state and local finances.  Either there are announced layoffs or workers are accepting lower wages, lower benefit levels, or must contribute more heavily to those benefits.  That leaves much less discretionary spending.  All levels of state and local governments are cutting spending.  A similar drama, of course, is now playing out in Washington, D.C.  The current soft patch will not be met with additional government spending or, according to the Fed, QE3.
  5. Remember, the soft patch of the summer of ’10 ended with the QE2 stimulus and additional deficits with the extension of the Bush tax cuts.  The result was at least $600 billion of money printing to purchase the Treasury Notes required by the deficit.  In addition, the sub-par recovery to date has been supported by the most massive fiscal and monetary stimuli in history.  Without such additional support, either through additional deficit programs or QE3, the soft patch could easily turn into outright recession.
  6. Like its predecessors in Japan and the U.S., the European debt crisis will be a long-term drag on world consumption.  No matter what the outcome is for Greece and the other weaklings in the European Union, the European banks are stuck with a lot of underwater sovereign debt.  There has even been some negative impacts on the U.S. muni market as one European bank, Dexia SA, a large insurer of U.S. muni debt, is overly exposed to Greek bonds resulting in rising yields on those U.S. muni issues.  The experience of Japan for the past 20 years and that of the U.S. for the past 2, along with the now famous  research of Rinehart and Rogoff, strongly suggests that, when banks hold impaired assets that aren’t recognized in their financial statements, lending dries up.  The current Dexia situation is a good example.
  7. And so it is in the U.S. as lending continues to disappoint.  Commercial and Industrial loans at U.S. commercial banks peaked in October ’08 at $1.6 trillion and fell to $1.2 trillion by last October (or by nearly 25%).  Since then (as of May) they have risen 4.3%, but most of that was due to student loans with federal guarantees.  The banks all comment that there is really no loan demand.  Clearly, large cap corporations have excess cash on their balance sheets, and they all use the credit markets for their borrowing needs.  That means that small and medium size businesses that must borrow from a financial institution either don’t want to borrow or don’t qualify under current bank lending standards.  In either case, since small business drives employment, the lack of lending is not a good sign.
  8. The only really good sign has been large cap corporate profits.  But even these are worrisome.  Having grown at double digit rates since the doldrums of ’09, forecasts of profit growth are now migrating to single digits with a downright negative tone to guidance going forward.  And, speaking of the markets, Treasury yields have fallen dramatically over the past 4 months.  The 10 year Treasury yield has fallen below 3% from 3.72% in February and 3.57% in April.  Usually, the bond market sees the correct direction of the economy before the equity market.  Bonds seem to be indicating more than just a “soft patch”.
  9. Lastly, recent statements by Fed Chairman Bernanke, usually the biggest cheerleader in Washington, D.C., and Fed Governor Dudley indicate that they see trouble ahead.  Dudley recently said that “the recent disappointing data suggest that downside risks to the outlook have increased”, and he specifically mentioned a) high oil and commodity prices, b) declining home prices, c) slowing consumer spending, and d) aggressive government spending cuts or tax increases.  In a June 7 speech, Bernanke was downbeat about the economy and sounded somewhat frustrated.  “Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established,” he said.  If these guys are worried, I think we all should be.

Conclusion

There are so many headwinds that the most rational view appears to be that the “soft patch” will likely turn into recession.  Employment and Housing are not improving; there is negative stimulus emanating from all levels of government, and, because this is a balance sheet recession, the economy has not responded well to massive stimulus. Lending in the U.S. has disappointed, and the European debt crisis will turn the lending spigot off there as well.  Corporate guidance has turned negative, and the bond market is indicating economic issues ahead.  Finally, the Fed itself is worried.  Initially, there won’t be QE3.  But, I suspect that, if a recession begins to unfold, we will see a QE3 and more fiscal stimulus.  The dollar will weaken further.

Robert Barone, Ph.D.

June 17, 2011

Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.  He is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).

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

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778

 

June 13, 2011

The Concept of Inflation as a Measure of Standard of Living

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:19 PM by Robert Barone

There is a debate in financial circles as to whether or not we even have inflation, and, if we do, should we even worry about it.  As expected, the chief monetary and fiscal officers of the federal government deny that inflation is a problem or that their policies have anything to do with it.  This was reaffirmed by Chairman Bernanke in his talk to The International Monetary Conference on June 7.  St. Louis Federal Reserve Bank economists, Chen and Wen, in a recent paper1 using data from prior oil shocks, conclude that while such oil price shocks had significant “inflationary” impacts in the 1970s and in the early 1980s, today, rapidly rising oil prices appear “to have only transitory effects on headline inflation and virtually no impact on measures of underlying inflation”.

Statistical Proof

Much of the debate centers around semantics and the “meaning” of the word “inflation”.  If you adopt one meaning, as Chen and Wen do, then inflation is not an issue.  If you happen to believe that inflation in the U.S. is actually measured by the “core” CPI numbers reported by the Bureau of Labor Statistics (BLS), then you, like our government leaders, shouldn’t be concerned.  However, despite the fact that Chen and Wen conclude that inflation is not a problem (at least relative to the price of oil), in a footnote there is an admission that their conclusions are based upon their definition of inflation.  “Although the effect on inflation [of oil price shocks] is transitory, the effect on the price level is not, because inflation is defined as the rate of change in the price level, not the price level itself” [emphasis added].  An appropriate interpretation of this is that we can have high inflation in the sense of high permanent prices, but we shouldn’t worry about it because it will disappear as soon as the underlying cause disappears.

The Standard of Living Concept

On the other hand, if your definition of inflation is a concept that measures, not prices alone, but “standard of living”, then the rest of this blog may be relevant to you.  Under the “standard of living” definition, the general price level can actually be falling but “inflation” can be an issue if incomes are falling faster than prices, and, thus, the standard of living is declining.

In his 1937 book, Seven Kinds of Inflation – and What to do About Them, Richard Skinner identifies four kinds of “absolute” inflations and three kinds of “relative” ones.  Absolute inflations include:

1.  Rising prices of fixed income securities

2.  Rising prices of land, equity securities and business values

3.  Rising short-term interest rates

4.  Rising general prices and living costs.

Today’s definition of inflation as measured only by the CPI only captures item 4, but we all recognize items 1 and 2 and refer to these as “asset bubbles”.  Relative inflations include:

5.  Growth in debt compared to wealth

6.  Growth in interest charges compared to income

7.  Growth in living costs compared with income.

Everybody now recognizes that item 5 describes the last two decades, and it appears that, with rising costs of vital food and energy commodities, item 7 would appear to apply today.  As debt costs rise, like those in Greece, we know that item 6 is also real.  So, of the seven kinds of inflation described by this 1937 work, we easily recognize six of them.  Of those six, two are commonly referred to as “asset bubbles” (items 1 and 2), and three are recognized as economic problems, but not categorized as inflation (items 5, 6 and 7).  Only one, rising general prices and living costs (item 4) is, today, actually called “inflation”.

Who is Right?

As could be expected and briefly described above, the government (Geithner, Bernanke) is in the camp that denies that inflation is a real issue.  They will defend this position as long as they have an argument that is even mildly credible.  And there are a whole set of well respected economists who believe that inflation isn’t an issue to worry about.  David Rosenberg (Gluskin Sheff), for example, believes that deflation is a bigger threat because of stagnant real incomes, high debt levels, and significant balance sheet issues for America’s consumers due to the real estate depression.  On the other hand, there are those pro-inflationists who point to $4/gallon gasoline and rapidly rising food prices, which they blame on QE1 and QE2, as proof positive that inflation is rampant.  So, who is right?

Actually, both are.  Rosenberg’s “deflation” is a “standard of living” concept.  One might categorize it as close to Skinner’s “relative” inflation concept (item 7 above – incomes not keeping up with prices), while the pro-inflationists are referring to one of Skinner’s “absolute” inflation concepts (item 4 above – rising general prices and living costs).

Cost-Push Inflation

Cost-push inflation is the kind that some American’s may remember from the 1970s.  Cost-push inflation is generally caused by input factor “shortages”, usually labor.  These could be real shortages or contrived shortages. They are real if the economy is operating at full or near full employment.  And the mild inflation we experienced in the early part of the last decade could possibly be attributed to such shortages.  In the 1970s, they were contrived.  At that time, unions were much stronger than today, and they could tie wage increases to an increase in the CPI measure.  As companies raised prices to protect profit margins from increasing wages, another round of wage increases resulted.  A vicious cycle had been created, one that could occur even when the economy was not operating with full employment.  Thus, the term “stagflation” was born.

We clearly do not have this type of inflation today.  First, unions represent a much smaller percentage of the employed labor force.  And, the industries in which they are strong are all either struggling (e.g., autos, or government employees) or are highly cyclical (construction and transportation).  Unions, today, do well just to hold wages and benefits at current nominal levels, and, most are making concessions.

Asset Bubbles

The next type of inflation, asset bubbles, has little to do with capacity constraints or restricted production inputs.  This generally occurs when a particular asset or class of assets begins to rise in price usually due to some basic economic change (innovation, government policy etc.), and early players in the bubble make “easy” money.  A large swath of the public is attracted to the game and asset prices are bid up to a crescendo peak, with each player having little use for the asset itself except to “flip” it for a quick profit.  Such bubbles always end in disaster for the late entrants, and oftentimes for those who weren’t even playing.  The recent U.S. housing bubble and the dot.com bubble are two good examples.  Some say that QE1 and QE2 has turned the current equity market into another such bubble.  That remains to be seen.

Currency Depreciation

Depreciation of the currency relative to other currencies is another significant source of inflation.  This source could be significant for a country that imports a large amount of vital commodities and other goods and services.  The U.S. falls into this category with large importations of oil and manufactured goods.   The work of Raphael Auer2, another Fed economist (Dallas), indicates that because of the volume of Chinese imports and their resultant weight in American’s inflation indexes, the appreciation of the Yuan would “substantially alter the competitive environment on many U.S. markets and consequently lend to widespread inflationary dynamics”. Thus, as the dollar falls in value, the dollar cost of imported goods rises.  And, since the dollar is the world’s reserve currency, and most international trade is done with dollar payments, dollar weakness is a significant source of inflation.  With real wages stagnant and median household income down to 1997 levels in real terms, the increases in the prices of energy and imported manufactured goods have lowered the standard of living for most Americans.

Conclusion

In conclusion, “inflation” in the standard of living sense is clearly a problem today.  Unlike cost-push inflation, this is not a self-feeding spiral.  So, the statements of government officials, like Geithner and Bernanke, that proclaim that the “inflation” is “temporary”, are not exactly false, but they are misleading.  This “temporary” inflation will end when the dollar stops falling in value.  But, when will that happen?  That will happen when the financial repression of interest rates and money printing by the Federal Reserve ends and a real solution to the structural fiscal deficit is crafted.  Given the nature of politics in the U.S., those events may still be a long way off.  Unless there is some international disaster that causes a run to the dollar as a safe haven (a phenomenon that appears to be getting weaker and weaker), the “temporary” time frame may be significantly longer than the rhetoric implies.

The price of gasoline can, and as of this writing, has moved downward from its $4/gallon level, due mainly to falling demand. But, because of dollar weakness, it is unlikely to fall to where it was a year ago.  And, even if the dollar’s value stabilizes, all this means is that prices stop rising, not that they return to their lower levels.  Clearly, without commensurate rises in wage and income levels, the standard of living will continue to fall.

It is a disservice to Americans to assure them that “inflation” is “temporary”, and therefore not a policy issue when there is ample evidence that the very policies of the government (money printing and uncontrollable deficit spending) are the root causes of the declining standard of living and are unlikely to be reversed anytime soon.

Robert Barone, Ph.D.

June 7, 2011

1Mingyu Chen and Yi Wen, Oil Price Shocks and Inflation Risk, Federal Reserve Bank of St. Louis, June, 2011.

2Raphael Auer, “Exchange Rate Pass-Through, Domestic Competition and Inflation: Evidence from the 2005/2008 Devaluation of the Renminbi”, Working Paper No. 8, Federal Reserve bank of Dallas, January, 2011.

Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.  He is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).

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

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

May 31, 2011

Greek EMU Exit: More Pain than Gain

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 11:43 PM by Robert Barone

In a recent blog post, we argued that, despite her credentials, Ms. Lagarde may not be the best choice for heading the International Monetary Fund (IMF) because of her bias to protect the French, German and European banks from the losses they will have to take in a Greek default, and that she will pursue the same “extend and pretend” policies that were put in place a year ago rather than face up to the fact that we are dealing with insolvency, not temporary illiquidity.

The Moral Hazard Expectation

It is clear that Greece will never be able to repay its debt in today’s Euros, and European banks are clearly in jeopardy.  Yet the market has yawned, and European bank equity values have been untouched.    A comment received from a colleague regarding that blog post read, in part:

If she [Lagarde] gets into position and kicks the ball down the road a ways, it will only be to give these big banks a chance to off-load and write-off Greek credit over a few years which will make it more palatable when the time comes to restructure.

The market appears to have much the same attitude expecting the governmental institutions to save the “systemically” important financial institutions.  Moral Hazard is now the expectation.  Not only are all depositors implicitly protected, but so are the shareholders, bondholders and the managements.  We always thought that investing was a risk-reward business.  Investments that fail are supposed to penalize the investor through a monetary loss.  There isn’t supposed to be a floor of book or par value supported by public funds.

The Implications of Additional Austerity

We suspect the reason for the kid gloves treatment is that the alternatives inflict too much short-term pain.  As mentioned above, a Greek default significantly impacts most large European banks.  Rather than recognize the impairment of the investments in Greek debt, in exchange for additional monetary support, the European Central Bank (ECB) and IMF will likely impose even more stringent austerity measures on Greece than the ones that currently exist and cannot be met.  What isn’t factored in is the impact this will continue to have on the Greek economy and its population.

It was only 10 years ago (2001) that the government of Argentina was compelled by the IMF and other large institutional debt holders to apply more and more austere measures on their economy in order to pay back debt.  In the month of December, 2001, the austerity imposed was met by protests which quickly erupted into revolution, governmental overthrow, and eventually a tacit default.  Is this where we are heading again?

Given the resistance of the Greek populous to the existing imposed austerity, additional austerity could trigger a popular uprising and result in a Greek exit from the European Monetary Union (EMU), i.e., the Euro, or from the European Union (EU) itself.  The founding Maastricht Treaty (1992) and original amendments didn’t discuss provisions for a member’s exit from either the EMU or the EU.  The Treaty of Lisbon (2009) does allow for an exit from the EMU, but that appears to be predicated on a negotiated rather than unilateral withdrawal.  It is clear, however, that the EMU was meant to be an irreversible arrangement. (For a detailed discussion, see P. Athanassiou’s ECB working paper entitled “Withdrawal and Expulsion from the EU and EMU” at http://www.ecb.int/pub/pdf/scplps/ecblwp10.pdf)

The “New Drachma”

Putting aside the legal questions, an exit from the EMU and formation of a new Greek currency (call it the “New Drachma”) has its own set of troubling issues.  Once again, a look at the recent Argentine experience is enlightening.  A decision to leave the EMU would need to be done quietly, as public knowledge would cause a run on the banks to acquire Euros causing nearly instant failures in the banking system.  So, severe restrictions on Euro withdrawals would have to be imposed, like the much hated “corralito” that was imposed in Argentina in ’01. That government imposed policy restricted withdrawals to a nominal amount per week.  This was a key repression that led to the social unrest, riots, and the eventual toppling of the government.

Next, Greece would need to decide what to do with its debt.  Hard choices would have to be made on externally held debt. Any attempt on the part of the Greek government to convert externally held debt to the new currency on a 1:1 basis would be met with massive resistance.  Keeping external debt denominated in Euros would become crippling as the value of the “New Drachma” would immediately devalue in the forex markets.  And, all of the “extend and pretend” would be for naught, as the Greek sovereign assets on the balance sheets of the banks would be repaid in a devalued currency.

Impairment is Inevitable

Thus, the results of an imposed austerity likely leading to a Greek exit from the EMU are the same as a simple recognition on the part of those banks that hold Greek sovereign debt that those assets are impaired.  Facing up to this basic problem would seem to be a better than the current “extend and pretend” approach in which we ultimately end up in the same place, but without the social unrest and bloody carnage that accompanies it.

Recognizing today’s value of the Greek debt on financial institution balance sheets is called “transparency”.  Accounting standards, both in the U.S. and internationally, have been pushing for transparency for two decades.  Yet, now, governments are madly scrambling to cover up the true values of such assets on the books of their “systemically” important institutions.

There are also tens of billions of dollars of Credit Default Swaps (CDS) outstanding on Greek sovereign debt.  Regulators failed to deal with the capital issue in the CDS marketplace in the aftermath of the ’08-‘09 AIG meltdown, so it is impossible to predict the effects of a Greek default on this marketplace because there is no information on CDS counterparties and their capital positions. But we suspect these markets, being unregulated, continue to be over-levered.

“Extend and Pretend” Causes Stagnation

The interconnected nature of today’s global financial system implies that many other banks around the world face asset impairments and a need for more capital. Many banks could fail.  The stockholders and bondholders of these institutions should suffer losses, and not be recipients of the “moral hazard” of government protection.  There will be terrible short-term pain.  But, history shows that the pain of balance sheet depressions, while severe, is short-lived.  The system returns to health with huge lessons learned about risk.  “Extend and pretend” only imposes a long-term period of economic stagnation as the cancers on bank balance sheets fester.  Japan’s is a 20 year example of the impact of unrecognized bank losses on the economy.  In an interview given to Investors Business Daily (“Slow Growth Normal For Post-Fin’l Crisis Recoveries”, Norm Alster, 5/23/10) by Vincent Reinhart regarding the paper he recently wrote with his wife, Carmen, concerning the aftermath of 18 financial crises (see After the Fall, 8/17/10), in Japan, “the banks were allowed to carry bad assets on their books at inflated values.”  As a result, “property prices have declined for 20 year”.  As an overview, Reinhart concluded that “the government’s willingness to let banks carry bad debt rather than force them to take losses tends to stretch out the process of deleveraging.  When you let banks carry their assets at high values relative to their market values, it freezes that market”.  His prescription: “Recognize the losses … Take the hit”.  Since it appears that the inability to restart America’s economic engine is partly due to bank balance sheet impairment, why is Europe about to go down the same road?

Robert Barone, Ph.D.

Matt Marcewicz

May 31, 2011

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

May 20, 2011

Commentary- Citi & Pandit

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 4:43 PM by Robert Barone

Vikrim Pandit was named CEO of Citigroup in December, 2007.  Most people have forgotten that he pocketed at least $165 million when he sold his hedge fund, Old Lane Partners, to Citi.  His hedge fund was shut down in the middle of 2008 due to investor redemptions, forcing Citi to write down the value of the poor investment.

As per the Wall Street Journal, by February 2009, taxpayers gave Citi $50 billion dollars in capital, and guaranteed $301 billion of bad debt.  The excuse given for taxpayers bailouts of the mega banks is that “credit is the life blood of the economy.  If the credit system isn’t working then firms cannot finance themselves, people cannot borrow to buy a car, to send a student to college, to buy a house.”
 (Bernanke 9/25/08).  So, let’s take a look at the “credit flow” Citi has done since its taxpayer bailout and since Mr. Pandit gained control.

From Citi Quarterly Statements : Numbers in Millions of Dollars
 

12/31/2007

3/31/2011

% Change

Consumer Loans

592,307

441,213

-25.5%

Corporate Loans

185,686

195,923

5.5%

Total Lending

777,993

637,136

-18.1%

It doesn’t appear that Citi, under Pandit, has lived up to the lending mandate that was accepted along with TARP funding.

It is also important to remember what Citi’s achievements have been during a period when rates paid on deposits and other borrowings have been essentially zero.  It is easy to make money when you borrow for next to zero, and buy treasury bonds.  This subsidy has come directly out of the incomes of retirees, savers, pension funds, and municipal cash accounts.  Yet, for its size, Citi has barely been profitable.  Imagine what its performance would have been if the Fed hadn’t repressed interest rates for the past 3 years.

At the end of 2007, Citi had 4,905.8 million fully diluted shares outstanding (10Q). By March 31st 2011, there were 29,965.8 million shares, a dilution greater than 6 fold.  Since the dilution, Citi has done a 1-10 reverse split.  Usually, reverse splits occur because a company’s stock price is languishing.  Citi’s split is no exception.  Since that split, the stock has fallen an additional 10%.

So, why reward a manager, who has already been paid hundreds of millions of dollars by the company for a fund that had to be shut down at a huge loss to the shareholders, with a four year no cut contract worth many more millions with the only criterion being that the company simply survives. We don’t think that diluting shareholders and shrinking business all while being coddled with Federal Reserve subsidies deserves a massive pay raise.

“This time, CEOs won’t be able to use taxpayer money to pad their paychecks or buy fancy drapes or disappear on a private jet,” Obama said. “Those days are over.” (2/24/09)  Apparently, those days have now returned.

Robert Barone, Ph.D.

Matt Marcewicz

The mention of companies in this article should not be considered as an offer to sell or a solicitation to purchase any security and or investments of the companies mentioned.  Please consult an investment professional on how the purchase or sale of such investments can be implemented to meet your particular investment objectives and goals.Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

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