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.

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.

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.

 

February 8, 2012

Avoiding The Austerity Death Spiral

Posted in bail out, Banking, Bankruptcy, Ben Bernanke, Big Banks, Economy, Federal Reserve, Finance, government, investment advisor, investment banking, investments, Senate Banking Committee, taxes, Unemployment tagged , , , , , , , , , , , , , , , , , at 8:19 PM by Robert Barone

Over the past four years, the slow creep of government into the private sector has become a gallop.  Unfortunately, a high level of structural unemployment is the unintended consequence of social engineering, picking winners, over-taxing and over-regulating every aspect of the business process.

The conventional wisdom is that a balanced budget will be a magic solution to the sluggish economy and the employment situation, but if it is done with just austerity and tax hikes but without relief from an overbearing set of governments on the business sector, what we will get is an “austerity death spiral.”  Federal Reserve Chairman Ben Bernanke said as much to the Senate Banking Committee on Tuesday.

Intervention is the Norm

We now live in a world where government intervention in the business process is expected.  When any sort of economic issue arises, government is now expected to fix it.

  • Financial institutions in trouble?  No problem – the taxpayers, via the government are expected to bail them out!
  • Domestic auto companies historically made awful decisions around retiree medical and pension issues and, as a result, can’t compete and are staggering toward bankruptcy.  Again, no problem.  Ask the government to shore them up, even if it means trampling on bondholder contract rights like in the General Motors case.
  • Some homeowners can’t, and others don’t want to make their mortgage payments.  That’s easy.  Ask the government to intervene, stop or slow the foreclosure process, and, perhaps, even require the lenders to reduce principal balances! This deal is in the works now with the government prepared to offer big lenders like Citigroup, Bank of America, Wells Fargo and JPMorgan Chase money to offset losses on short sales.

The markets now expect intervention.  When the government intervenes in an economic issue, the markets rise.  If the government doesn’t, it falls precipitously. On September 29, 2008, the Dow Jones Industrial Average (DJIA) fell 778 points when Congress failed to pass the initial TARP legislation; From the time QE1 began in November, 2008 until it ended in March, 2010, the DJIA rose 28% or  2,378 points.

QE2 elicited a similar market response, 1,199 points (10.7%) from November, 2010 to June, 2011, even more if you go back to August when Bernanke articulated the strategy in Jackson Hole, Wyo.

In late November, 2011, on the day when the Fed gave unlimited swap lines to the European Central Bank (ECB), the DJIA rose 490 points; it rose 337 points just before Christmas when the ECB opened its lending facility to 540+ European banks.

I suspect we will see similar market reaction if the Fed goes through with its hinted at QE3.

Unintended Consequences

Unfortunately, nearly every government intervention carries with it unintended consequences, and, if such interventions interfere with the free market processes, they have long-term negative implications on economic growth. Recent examples in the U.S. include the Keystone Pipeline and the National Labor Relations Board’s attempt to block Boeing from opening a plant in South Carolina.

Nearly every economic malady that exists today is directly traceable to the unintended consequences of government interference in the economic process or via its attempt at social engineering:

  • Sub-prime and housing crisis:  It is widely recognized that this was caused by three concurrent factors: 1) an extended period of low interest rates engineered by Greenspan’s and Bernanke’s Fed; 2) the social engineering goals of the Community Reinvestment Act (CRA); 3) the political and monetary aspirations of Fannie Mae and Freddie Mac executives and sponsors;
  • Social Security and Medicare unfunded liabilities: As the baby boomer generation reaches retirement age, unfunded liabilities will increase by more than $3.5 trillion each year.  To show how absurd this is, the payroll tax reduction, in effect since January 1, 2011, and currently an issue in the Congress, simply puts the Social Security system ever deeper into debt that cannot be repaid without hugely inflated dollars;
  • Unfunded pension liabilities:  While some private sector corporations have unfunded pension liability issues, the bulk of the problem lies at the local, state and federal levels;
  • High structural unemployment: As alluded to earlier, impediments to business from all levels of government, but especially from the federal government, are a huge issue.  Recent legislation, including Sarbanes-Oxley, Dodd-Frank, and Obamacare, is crushing small business.  In addition, business must be confident that the future environment will be friendly.  So, the notion of a “temporary” tax reduction doesn’t reduce business uncertainty, as businesses invest for the long-term.

This last item is particularly poignant.  In a three part op-ed series published by Bloomberg in mid-January, Carl Pope, former chairman of the Sierra Club, bemoans America’s loss of manufacturing jobs.  “It’s not the wages, stupid!”, he says.  If wages were key, how is it that Germany, where wages are higher and unions stronger, enjoys a growing manufacturing base?

For the auto industry, which in 1998 had over 70% of the U.S. domestic auto market but now has 44%, it was the health care and pension costs of its retirees that caused the industry’s economic crisis, he says.  Since the turn of the century, America’s manufacturing base has shrunk by one-third, not because of wages, which are similar to wages paid in the rest of the world, but the lack of support or even outright hostility on the part of government.  (When even the Sierra Club recognizes that government is choking free enterprise, the issue must be terribly obvious!)

November 23, 2011

Super Committee Could Hurt Dollar’s Reserve Currency Status

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 tagged , , , , , , , , , , , , , , , , , , , at 4:30 PM by Robert Barone

NEW YORK (TheStreet) — The decisions of the Super Committee are likely to have more far-reaching implications than are currently envisioned, as the deliberations have been cast only in political terms by the media. There are, however, significant long-term economic implications.
As we have seen over the past couple of weeks in Europe, contagion can spread like wildfire. The bond yield spreads to U.S. Treasuries or German Bunds on all European peripheral country debt, and even on the debt of AAA rated (at this writing) France, have widened significantly and are displaying huge volatility depending on the day’s headlines.
>>Debt Super Committee Could Spoil the Holidays
Luckily for the U.S., the dollar is still the world’s reserve currency and, in a world of fiat currencies, shows up as the least risky because of its worldwide liquidity and its unabashed penchant to use its money printing press in a financial crisis. So, despite the imbalances clearly present in the U.S. today (see U.S. Debt Crisis: What’s the End Game? ), there still exists a “flight to the lowest perceived risk” (formerly known as “flight to quality”), when crisis and uncertainty rear their ugly heads.

Benefits of Reserve Currency Status

The rapid spread of the contagion in Europe should be a wake-up call to U.S. policy makers, especially the Super Committee. Any stumble or failure to propose something significant in the form of deficit reduction could further jeopardize the dollar’s reserve currency status and bring the day of reckoning perilously closer. The Nov. 14 edition of Barron’s (Enter the Yuan) set forth five benefits of reserve currency status:
  • Investor willingness to hold your currency and paper;
  • The ability to print money to purchase foreign assets — without paying any interest;
  • Easy issuance of debt and worldwide acceptance;
  • Deeper financial markets ultimately benefiting your financial institutions;
  • Conducting trade in your currency which avoids exchange rate risk and benefits your exporters.
Think of what could happen to the U.S. without reserve currency status. Like what has already happened in the European periphery countries, interest rates would rise. This will occur even if the U.S. shares reserve currency status, which is the most likely initial scenario. I (see Wow-II! That’s A Lot of Interest!) and other prominent economists have estimated the cost of debt in the U.S. if rates rise. Some possible scenarios are truly frightening in that the cost of the debt relative to the federal budget and GDP could put the U.S.’s debt burden on par with or higher than that of Greece, Italy and the other countries involved in Europe’s debt crisis. 
For sure, as I opined in the above referenced blog on Dec. 1, 2010, “[g]iven the structural nature of the deficit and the difficulty of slowing or reversing defense costs or the costs of ‘social’ categories, even small upward changes in interest rates … will exacerbate the deficit and economic growth issues.” Thus, preserving reserve currency status, just for the lower interest rates that accompany it, is critical.

Recession Implications, QEs and the Financial System

While recent data suggest that a U.S. recession is not imminent, some leading edge economists and even the San Francisco Fed believe that the inevitable recession in Europe in 2012, a slowing growth rate in Asia and China, and fiscal austerity at the state and local levels could tip the U.S. into recession. The San Francisco Fed says this probability is above 50%. A renewed recession will certainly cause the Fed to embark upon additional QEs, and the Administration and Congress will react by increasing the deficit (after all, it is an election year!). This will further erode the world’s confidence in the dollar as the world’s reserve currency.
The U.S. financial system was not “fixed” by TARP or Dodd-Frank. MF Global has shown that some of these institutions still have insanely high levels of leverage and are more than willing to make “all in” bets. An implosion in European financial institutions may negatively impact both the mid-sized and the Too Big to Fail institutions and cause further credit tightening. Under such circumstances, I can envision another TARP-like response from the Treasury and Fed with more money printing and secret lending further eroding the dollar’s status as the world’s reserve currency.
One has to wonder why China hasn’t come to Europe’s aid given that China exports as much or more to Europe as it does to the U.S. The answer could be that China has a long-term plan to vault the Renminbi (RMB or Yuan) toward reserve currency status. The benefits are numerous as outlined above. Already McDonalds, Caterpillar, Unilever, UBS, Volkswagen and the World Bank have issued bonds denominated in RMB in the Hong Kong market. It is no secret that China wants its emerging market trading partners to settle merchandise trades in RMB and wants a financial center on par with New York and London on its mainland. So, a flailing Euro and QEs in the U.S. advance the RMB as a potential reserve currency.
The importance of the Super Committee recommendations for the dollar’s status in the world and the special privileges, liquidity, and low borrowing rates that accompany that status cannot be overemphasized. Failure to make significant progress will only hasten the day when there won’t be a “King Dollar.” The end result will be higher borrowing rates, lower economic growth, a continuation of depressed economic conditions, and a further lowering of the U.S.’s standard of living.
TheStreet
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.

November 9, 2011

Euro End Game: All Roads Lead to Monetary Breakup

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 tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 6:39 PM by Robert Barone

— Three major issues must be resolved to save the European Monetary Union (EMU): The value of sovereign debt; the European bank capital issues; and the fiscal capacity or will to provide the needed financing. Unfortunately, no feasible solutions exist. The politicians have done everything they could to keep the market on the edge while, at the same time, continuing to kick the can down the road. The farther the can is kicked, the more painful and costly the ultimate resolution — the breakup of the EMU.

The Value of Sovereign Debt

As of this writing, the haircut on Greek sovereign debt currently on the table is 50%. The French want as small a discount as possible (it was originally set to 21% in the July agreement which was just ratified by the EMU countries a couple of weeks ago) because French banks hold volumes of Greek sovereign debt.

Germany, the other major player in the drama, wants a larger discount to force the private sector to contribute to the resolution, and because they know that they, and they alone, are the ultimate guarantor. The 50% haircut, however, is really not 50% because the EFSF and ECB, which hold 55% of all Greek debt, are exempt from the
haircut. So, at the max, Greece will be relieved of 22.5% of its debt.

However, in order to give Greece a half a chance to survive within the euro circle, the discount should be 80%, not 22.5%%. Even at an 80% discount, Greece’s Debt/GDP ratio will still be greater than 90%. At a 22.5% haircut, their Debt/GDP ratio will be so high, and interest payments to outside debt holders so onerous that it will require too much austerity. As we have just witnessed, Greece cannot meet the current required austerity measures imposed by outsiders. If the haircut on the Greek debt is too small and austerity is too severe, which it will be under the current set of principles being discussed, social unrest will continue. 

Ultimately, the Greek people will elect politicians who vow to remove the imposed austerity. The rise of Hitler was partly the result of imposed “reparations” from the previous war and the hyperinflation that resulted. If still inside the EMU, the problem of the value of the Greek sovereign debt re-emerges under the scenario now on the table. So, it is vital that the Greek debt haircut be large enough to give Greece at least a chance to succeed within the EMU. Of course, that assumes that there is a shift within Greece away from the entitlement mentality
that pervades the culture and that, given a second chance, they will adhere to a fiscal discipline. History indicates low odds of this.

But there are more issues that arise in the scenario in which Greece is given a second chance and kept inside the EMU. The slippery slope is that if the bond haircut is high, then Portugal, Ireland, Spain and Italy see that Greece has been given a second chance with much of its debt forgiven, they will want the same treatment. After
all, why should these countries institute austerity to pay the private sector and often foreign debt holders when Greece doesn’t have to.

In order to avoid the contagion that the others will want the same deal as Greece, there will have to be a consequence that dissuades them. The only consequence I can think of that is serious enough to dissuade them is expulsion from the EMU. Therefore, in order to avoid contagion under a scenario of an 80% bond haircut, it is
essential that Greece leave the monetary union, and that the EU set up and strictly enforce expulsion criteria.

Ultimately, though, because the four problem countries all have the same entitlement mentality, they will never be able to maintain the required fiscal discipline, and will ultimately be expelled. Apparently, the European politicians recognize this.  So, the 22.5% haircut deal currently on the table simply kicks the can further
down the road. The deal on the table cannot ultimately work.

European Bank Capital Issues

No matter how it is sliced or diced, Europe’s major banks are undercapitalized, and that is being kind. If
the sovereign debt they hold is marked to market, they are all insolvent. As we know from America’s S&L crisis in the ’80s and from the recent ’09 meltdown experience, a financial institution can operate in an insolvent condition for years, as long as it can get liquidity. In fact, there may still be such zombies in the U.S.

Enter the European Financial Stability Facility (EFSF). It’s function will be to support (i.e., buy) the underwater sovereign debt held on the books of Europe’s financial institutions at prices significantly above market, thus transferring the ultimate losses from the private sector to the taxpayer. The Fed did this in ’09, purchasing billions of mortgage-backed securities at above market prices from U.S. financial institutions. In effect, this is equivalent to the taxpayer making a capital contribution to the banks without receiving any ownership
interest. This is just a gift from taxpayers to stock and bond holders.

The ultimate capital contribution to the European banks will be in the trillion euro range, and it is likely that the EFSF will attempt to use leverage. But, because the capital contributions to the EFSF already being discussed (and I expect they aren’t as large as they need to be) are large relative to Europe’s GDP, there are likely to be ratings downgrades, causing interest costs to rise and making austerity in the EU even harder to bear. Under existing discussions, France, one of the two major characters in the whole crisis, is expected to make a contribution to the EFSF that is equal to 8% of its GDP. This alone will surely result in a ratings downgrade, as its Debt/GDP ratio has risen nearly 20 percentage points this year alone.

How long will the public endure the resulting austerity? Only long enough for the political process to elect leaders who promise to get rid of it. And, how do they do that? Exit the EMU.

Fiscal Capacity

It is clear that Germany and France are the key players (who are expected to be saviors) in this European drama. As explained above, as the drama unfolds, it is likely to put a tremendous strain on France’s fiscal capacity making it impossible for France to contribute further resources to the crisis (they are already on the hook for a significant contribution to resolve the Dexia issues). That leaves Germany as the last bastion of the euro. Think of the irony. The German people, by a large majority, never wanted to join the EMU. Their politicians brought them in kicking and screaming. Now, they are going to be asked to pay for all the entitlement and profligacy of their European neighbors. This just isn’t going to fly. When it gets to this point, and it will, Germany will simply say no, and that will be the end of the EMU.

Conclusion

It is already too late. The euro cannot be saved without the adoption of the U.S. federal model where the countries become the equivalent of U.S. states with one monetary and fiscal policy, ultimately run by Germany. Because of culture and history, the odds of this happening are about 0%.

The financial ministers can meet. There can be weekly, or even daily summits between the prime ministers. They can dream up debt Ponzi schemes with the EFSF, and can transfer losses from the private sector to the taxpayer. And, they are likely to do all of the above. But, ultimately, it is too late.

The EMU did not enforce its original rules, and now there is way too much debt. Like the S&Ls in the U.S. in the ’80s, it can be propped up for awhile. But, all of the actions that add debt or transfer it from the private sector to the taxpayer only make the final resolution more gut wrenching, difficult, and expensive. All roads lead to the breakup of the EMU. Better to do it now, in a controlled and orderly way, rather than let the happenstance of random events cause it to happen in the midst of a market crash.

Robert Barone, Ph.D.

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.

October 18, 2011

Seven Reasons Bank Stocks May Keep Falling

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 10:22 PM by Robert Barone

  • Occupy Wall Street – while not a cohesive movement, at least part of its birth can be traced to outsized Wall Street salaries and bonuses, especially since the taxpayer saved most of the TBTF banks.  Bank Transfer Day (11/5), the day on which Americans are supposed to transfer their deposits to community banks, is more symbolic than real, as the “Too Big To Fail” (TBTF) banks core consumer deposits are only a small portion of their liabilities and can easily be replaced with no or low cost funding from the Fed or elsewhere.  Nevertheless, Bank Transfer Day is a PR issue for the large banks;
  • Margin squeeze – TBTF have used the arbitrage spread between borrowing costs (near 0%) and Treasury yields (2%+) to profit.  And, the purchase of Treasury securities requires no capital under the capital regulations, as Treasuries are “risk free.”   The Fed’s new policy of “Operation Twist” targets  longer term interest rates and squeezes this arbitrage spread;
  • Volcker Rule – this has recently been put out for comment by the FDIC.  It severely limits trading profits made for the bank’s own account and is likely to have a big impact on TBTF trading profits going forward;
  • Debit card monthly fees – although such fees are a direct consequence of the limitation on debit swipe fees by the Fed under Dodd-Frank, and it was common knowledge that the TBTF banks would find a way to increase fees elsewhere to make up for their losses on the swipe fees, the timing has turned out to be lousy and the TBTF banks are taking a PR hit from the press, and even from the sponsors of Dodd-Frank who clearly knew that there would be unintended consequences;
  • Exposure to Europe – According to Michelle Bachmann, the U.S. TBTF Banks have a $700 billion exposure to European Banks.  So, a freezing up of liquidity flows to those institutions may have an impact on the value of such holdings.  It is clear that the Fed and the European Central Bank will intervene with massive liquidity injections if such events unfold.  Nevertheless, the risk of such a freeze up exists.  Furthermore, if contagion spreads because of a Greek default, there is no doubt that the TBTF equities will be negatively impacted.  So far, we have seen the equity prices of these behemoths ebb and flow with the news (or hope) out of Europe regarding their evolving “rescue” plan;
  • Mortgages & Foreclosures
    • Foreclosures at the TBTF institutions are rising because moratoriums have expired and “robo” issues have been addressed.  In addition, so called “Prime” loans in portfolios (usually “Jumbo” loans – those that are larger than the FNMA limits) are becoming a big issue as there is a clear trend toward rising “strategic” foreclosures.  In fact, Fitch recently downgraded many of these “prime” mortgage pools.  This calls into question the quality of what may be on the TBTF balance sheets in the form of such jumbo loans.  Furthermore, the fact that FNMA and FHLMC reduced their loan maximums on October 1st is destined to have a huge negative impact in states like CA and FL, where the prices of higher end properties will fall due to the unavailability of financing.  So, expect “strategic” defaults to rise rapidly in these states;
  • Lawsuits
    • Half of America’s mortgages are on MERS (Mortgage Electronic Registration System), but, in many states, MERS has no standing in foreclosure.  Theoretically every owner of a securitized pool should sign off on each foreclosure in the pool.  There could be hundreds, if not thousands, of owners in these pools.  In addition, many jurisdictions require that title transfers be recorded in county recorder offices.  Since that did not occur, lawsuits are now being developed against the major TBTF players for lost recording/title transfer fees.  The Dallas DA recently sued MERS and BAC for $100 million of such fees.  According to Mark Hanson, since MERS has been operating since 1995, there could be billions of dollars of such thwarted fees.   Because nearly every local governmental entity is hungry for funds, this could catch on like wildfire;
    • Bank of America’s (BAC) $8.6 billion global servicer settlement is in trouble, as NY’s AG Schneiderman says it should be closer to $25 billion, and he is getting support from other states, like CA.  The rumor mill has circulated the theory that if lawsuit settlements become outsized, BAC appears to have the option of bankrupting the old Countrywide unit, which it has kept as a separate legal entity since its purchase in 2008.  Imagine, though, the market reaction to such a move!
    • Lawsuits on mortgage trustees are just starting.  According to Bloomberg, US Bank, Bank of NY Mellon, Deutsche Bank, Wells Fargo, HSBC, BAC and Citibank (C) are the major mortgage trustees.  Bloomberg speculates that since these institutions didn’t underwrite, sell, securitize, service, or ship loans according to regulations, the odds are low that the trust departments got it right.  So far, NY’s Schnedierman has requested documents from Deutsche Bank and Bank of NY Mellon.
    • In early September the Federal Housing Finance Agency (FHFA), the receiver for FNMA and FHLMC, sued BAC, C, JPMorgan Chase (JPM), Barclays, HSBC, Credit Suisse, and Noruma Holdings demanding refunds from these institutions for loans sold to FNMA and FHLMC that were based on false or missing information about the borrowers or the properties.  The FHFA said that the two mortgage giants purchased $6 billion from BAC, $24.8 billion from Merrill Lynch which is now owned by BAC, and $3.5 billion from C.
    • Lawsuits and foreclosure issues are making the TBTF banks sorry they are in the mortgage business.  JPM’s Dimon announced that they are going to be leaving the mortgage business, and BAC announced last week that by year’s end they will stop buying mortgages from correspondents.

Not all of this appears to be priced in the market, so there may be continued downward pressure on the prices of financial stocks, especially TBTF, as events unfold, especially the potentially disruptive forces that Europe may unleash, or the conclusion that the foreclosure and mortgage lawsuits are larger and more significant than currently believed.

Robert Barone, Ph.D.

October 12, 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 received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778

October 10, 2011

Buy and Hope

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 10:10 PM by Robert Barone

Despite a preponderance of evidence, the markets continue to rely on the “hope” that Europe will solve its enormous financial issues, that the U.S. will somehow miraculously begin to grow at or above GDP potential, and that the emerging markets will continue to grow by exporting to the developed world.  There are those on Wall Street still pushing “buy and hold” indicating to clients that, based on forward earnings forecasts, the equity markets look cheap, as if those forward forecasts aren’t subject to downward revisions.  Thus, the “buy and hold” is really “buy and hope.”  There are no quick fixes to any of the economic problems so evident in a world awash in debt.

Europe

  • Europe is clearly entering a recession, and is likely to be in it for an extended period.
  • The value of the sovereign debt of the European periphery countries is a huge issue.  Greece can afford to pay “normal” interest rates on about 20%-30% of its current debt.  Therefore, when its inevitable default occurs (looks like soon), the haircut on its external debt may be as high as 80%.  Once the default is announced, the markets will pounce on the next weakest – at this time, that looks like Italy, although Portugal and Spain are also in the race..  To keep Italy from defaulting, the Troika (the European Union (EU), the European Central Bank (ECB), and the International Monetary Fund (IMF)) may have to finance Italy’s deficit and purchase its debt rollover for as many as 3 years.  The rollover of central government debt alone is €705 billion. The regional debt is also significant. The risk is that Germany or one of the other 17 European Monetary Union (EMU) members balk.
  • The real issue revolves around the European financial system.  There isn’t enough capital in it to mark the sovereign debt they hold on their books to market values.  The haircuts given to the peripheral sovereign debt when a Greek default occurs will cause an ugly reaction in the financial markets.  Huge liquidity infusions from the ECB (and likely the Fed) will be required.  Morgan Stanley says that €140 billion in new capital is needed, but I have seen estimates as high as €800 billion.
  • Discussions among Europe’s finance ministers about using the European Financial Stability Fund (EFSF) as a Special Purpose Vehicle to provide liquidity or to provide capital to the banking system (the discussion seems to change on a daily basis) have caused the financial markets to rise on such hope.  As far as I can tell, the €780 billion of capital that is being voted upon by the 17 EMU members (14 have approved so far) could be used as capital to lever up to higher levels and use the resulting funding for either or  both liquidity and capital.
  • This is all still in discussion stage.  Somehow, Greece miraculously found funds to keep itself solvent until mid-November, so the European finance ministers have kicked the can down the road for another month.  The real risk here is whether or not the Europeans can agree.  History is not on their side.  Unlike the U.S., the EMU requires unanimous consent and monetary contributions from each of its 17 members to cope with unusual circumstances not envisioned in the EMU treaties.  Malta and Cyprus have the same veto power as Germany.  It should be noted that, as of this writing, the Slovakia vote on an expanded EFSF is not a sure thing, and that Finland received special guarantees for its approval vote.  Imagine the chaos if every small member demanded special treatment – it could look like the earmark system used in the U.S. Congress.
  • Italy was recently downgraded 3 notches by Moody’s, from Aa2 to A2 with a negative outlook.  The Credit Default Swap (CDS) market believes Italy is still significantly overrated, as is most of the rest of Europe.  CDS may not be the best indicator of financial stability, but it appears that there are enough skeptics on European sovereign debt to make investors wary.  If much of Europe eventually gets downgraded, what kind of rating will the EFSF’s debt have?
  • In its current form, the EFSF must wait for a support request from a member country, and then must get unanimous consent from the 17 finance ministers.  (I smell gamesmanship in the form of holdout for special concessions – just like Finalnd!)

As you can see, the machinery is quite cumbersome and very slow to act.  Things must go flawlessly for Europe to avoid significant calamity over the next few quarters.  The excitement recently seen in the equity markets appears to be based on hope – not a very reliable investment strategy.

Japan and the Emerging Markets

  • Japan has too much debt coupled with deteriorating demographic trends.  Since the 1990s, they have not addressed the issues on their banks’ balance sheets, and real estate prices (land) have continued to decline for those two “lost” decades.  Their August industrial production numbers were weaker than expected.  Don’t look for Japan to lead. Their two decaded economic malaise may, in fact, be what is in store for Europe and the U.S.
  • There are also troubling signs in China and the emerging markets (BRICS).  HSBC’s PMI index for China has been below 50 for three consecutive months (below 50 implies contraction).  Whatever the case, growth is clearly cooling, most likely indicating some success in China’s fight against rising inflation, especially in real estate where prices are now flat to falling.  This, of course, is having a significant impact on natural resource and commodity prices.
  • It is unlikely that China, which still has positive, but slower, growth, will repeat the stimulus package they unleashed in ’09.  That helped the rest of the world climb out of recession.  The rapidly falling prices of industrial commodities (e.g., copper) is symptomatic of the slower pace of growth in the emerging world.
  • Some emerging markets, like Brazil, which have been fighting the inflation caused by the influx of capital from the developed world, are now seeing declining growth rates, most likely due to the slowing growth in the developed world which has a huge impact on emerging world exports and prices.

United States Housing Market

  • Housing normally leads the U.S. economy into recession, and then leads it out.  Not so this time.  Housing issues are getting worse, not better.  Prices, especially those of higher end homes, continue to fall, even with mortgage rates at historic lows (below 4% for 30 year fixed).  Qualifying is now extremely difficult and requires a large down payment.  On October 1, FNMA and FHLMC lowered the maximum amounts they will lend.  Since they purchase over 90% of all new loans made, this will significantly lower sales volumes, and eventually prices, in high priced areas like California.
  • Foreclosure trends are on the rise, both because the financial institutions have worked their way through the “robo” signing issues, and because most foreclosure moratoriums have expired.  Given the sorry state of housing, more and more underwater homeowners are simply giving up on ever seeing positive equity again.  “Strategic” defaults are on the rise.  These occur when a homeowner who can afford the payments walks away because the mortgage balance is significantly higher than the home’s value, and the owner believes it will be years, if ever, before he breaks even.  As a result, Fitch has recently lowered the ratings on what used to be called “prime” mortgage loans causing some dislocations in mutual and hedge funds that specialize in holding such non-agency paper, especially the ones that also use leverage.
  • Lawsuits are proliferating around mortgage issues.  The Mortgage Electronic Registration System (MERS), a private corporation with about 50 employees, claims to hold title to about half of the mortgages in the U.S.  They have filed foreclosure actions on behalf of the mortgage “owners” (there could be several hundred or even thousands of owners of a securitized pool).  Many jurisdictions require the “owner” to file the foreclosure.  Imagine having to get signatures of everyone that owns a share of a securitized mortgage pool each time one of the mortgages in the pool goes into default.  In addition, many jurisdictions require that title transfers be recorded in county recorder offices.  Since that did not occur, lawsuits are now being filed against major private sector mortgage purveyors (like JPM, or WF) for lost recording/title transfer fees.  The Dallas DA recently sued MERS and BAC for $100 million.  According to Mark Hanson, since MERS has been operating since 1995, there could be billions of dollars of such thwarted fees.
  • Mortgage trustees are also not immune from lawsuits.  According to Bloomberg, US Bank, Bank of NY Mellon, Deutsche Bank, Wells Fargo, HSBC, Bank of America, and Citibank are the major mortgage trustees.  Bloomberg speculates that since these institutions didn’t underwrite, sell, securitize, service, or ship loans according to regulations, the odds are low that the trust departments got it right.  So far, NY AG Schneiderman has requested documents from Deutsche bank and Bank of NY Mellon.
  • The $8.6 billion mortgage servicer settlement that Bank of America thought was a done deal has now fallen apart.  NY’s AG, Schneiderman thinks that the settlement should be closer to $25 billion.
  • With all of the lawsuits and the state of housing, the large mortgage originators are sorry they are even in the business.  Jamie Dimon recently announced that JPMorganChase may be leaving the business.  In early October, Bank of America announced they would stop their correspondent mortgage business by year’s end, which means that they won’t be buying mortgages originated by others.  One more nail in housing’s coffin.

So, let’s review: 1) Home prices continue to fall; 2) FNMA and FHLMC lowered their loan maximums; 3) Foreclosures are rising; 4) Lawsuits are proliferating on private sector lenders; 5) large private sector lenders are either leaving the business or curtailing it.  So, how is it that housing can lead the way out of the economic funk?

Other U.S. Indicators

  •  70% of GDP in the U.S. is from consumption.  The fact that real consumer income (after inflation) has fallen for three months in a row and is no higher than it was in 1997 is a very troubling sign because credit can no longer be used to consume.  In the months in which we actually see consumption rising, we see the savings rate fall.  Increasing consumption in an economy with falling consumer income can only last as long as there is savings.  So, it can only be a short-run phenomenon.
  • Washington, D.C. finds it impossible to come to terms with their overspending.  Nothing they have done, including the $1.5 trillion “Supercommittee” mandate will make a dent in the entitlement spending increases coming at us like a speeding train.  We know no changes in the entitlement rules will occur before 2013, at the earliest.
  • What is occurring at the Federal, State and Local levels is significant belt tightening.  President Obama’s Jobs Bill was DOA in Congress.  Because of the tax increases proposed, the Democrats even had a difficult time in finding a sponsor to introduce the bill.  With the funds provided in the ’09 stimulus package now gone, with a Congress not interested in more tax and spend, and with the Fed now out of real ammunition, there isn’t going to be much government help for a weakening economy.
  • Sarbanes-Oxley, Dodd-Frank, Obamacare, EPA pronouncements, other regulatory burdens, the uncertainty surrounding taxes and tax rates etc. has led to an environment of business uncertainty.  Under such conditions, there is virtually no chance that labor markets will pick up anytime soon.  As a result, consumer confidence continues to bounce along well below traditional recessionary levels.

 

Conclusion

The preponderance of the evidence makes it clear that the risks in the equity markets are to the downside.  There are no quick fixes to any of the European or U.S. problems.  Europe’s financial issues can easily morph into a worldwide financial panic.  The U.S.’s housing, deficit, and employment issues will linger without a new approach, one that we won’t see until at least 2013.  Safety is clearly a better investment strategy than hope.

Robert Barone, Ph.D.

October 10, 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 received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

 

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