February 16, 2012

Debunking the Warren Buffett Tax Deception

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

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

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

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

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

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

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

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

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

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

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

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

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

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December 13, 2011

How MF Global Almost Got Away With Everything

Posted in Banking, Big Banks, Europe, Finance, Foreign, investment advisor, investment banking, investments, sovereign debt, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , , , at 4:39 PM by Robert Barone

The MF Global (MFGLQ.PK) story is just another chapter in the continuing saga of the legal fleecing of America by a financial system joined at the hip in an “Unholy Washington-Wall Street Alliance.”

The rules of the game are such that the managements of large Wall Street entities are allowed to gamble with assets entrusted to them by an unsuspecting public. If the bets are successful, the spoils flow entirely to the management and the firm, with nothing going to the clients whose assets are at risk. On the other hand, if the bets fail, the clients take the entire loss! Unfair? Of course.

But, as you will see if you keep reading, MF Global’s client assets will not be “found,” and, worse, unless the NY attorney general becomes incredibly creative, no one is likely to go to jail because no laws appear to have been broken. MF Global is just another piece of evidence that the current financial system is addicted to and permits excessive leverage and is deeply flawed.

Until this is recognized and fixed, the financial system will continue to be besieged with crises spawned by Wall Street greed. There are likely other, yet to be discovered, atrocities lurking in the shadows.

Asymmetrical Borrowing Rules

It appears that MF Global, as well as every other major US investment banking firm, has taken “advantage of an asymmetry in brokerage borrowing rules that allow firms to legally use client money to buy assets in their own name,” Christopher Elias notes in a recent Thomson Reuters article.

Simply put, MF Global borrowed money, and, using that borrowed money, purchased the debt of the European periphery (Italy, Ireland, Greece, Spain, and Portugal) at very attractive yields. The borrowings and the debt purchased had the same maturity date, so the proceeds of the debt maturities were to pay back the borrowings. MF collected the difference between the low rate it paid on the borrowings and the high rate it received on the debt.

The euro debt it purchased was guaranteed by the European Financial Stability Facility (EFSF). To get the low rate, MF had to pledge collateral. So, it pledged the euro debt, and as additional collateral, it borrowed and pledged its clients’ assets, which assets it held as custodian. Looks like a no-brainer! So thought Jon Corzine and Co.

Margin in the US

In the US, a client with an account at a broker-dealer can place his assets in a “margin” account. The client is then allowed to borrow against those margined assets. There are rules for this called “margin requirements.” Generally, speaking, the value of the assets assigned to “margin” must be greater than the amount borrowed by a factor set by the Federal Reserve under Regulation T.

If the market value of the assets assigned to “margin” falls in value to the point where the margin requirement ratio is violated, a “margin call” is generated. The client either has to assign or pledge more assets to “margin,” or reduce the borrowing via a cash deposit. If the client fails to do either of those in the time allotted by regulation, usually three business days, the assets that were pledged to “margin” are liquidated (sold out) and the proceeds are used to offset the borrowings until the required margin ratio is satisfied.

Of relevance, clients who assign their equities to “margin” (the only other alternative is called “cash”) so that they can borrow against them also automatically grant their broker-dealer the right to “lend” their assets to another investor who wants to “short-sell” that particular asset because a short-seller must first “borrow” existing stock in order to “sell” it. The broker-dealer makes money by lending out equities in margin accounts to short-sellers. The everyday American investor is unaware of this, and earns nothing.

Leverage

So, how did MF Global lose client assets? In the US, broker-dealers can use margined assets as a funding mechanism, i.e., by borrowing those assets themselves and using them as collateral to borrow. But in the UK, those same borrowed assets can be pledged several times over (called rehypothecation), resulting in very significant leverage. That is, the client assets stand behind several borrowings rather than just one.

Buried somewhere deep in the legalese of the account forms (you know the pages and pages of legal gobbledegook that nobody reads because one has to be an attorney to understand it), the clients gave MF Global the right to transfer those client assets to its UK subsidiary and to “borrow, pledge, repledge, hypothecate, and rehypothecate” those assets.

According to the Thomson Reuters article cited above, such language is common in most large US broker-dealer agreements. That language allows the large broker-dealers to circumvent US law and take advantage of UK law where rehypothecation (leverage) is allowed.

The Impact of Margin Calls

For MF Global, the unanticipated “tail” event occurred. (“Tail” events are only supposed to occur very infrequently. However, in an unstable financial system, they occur often.) When the value of the European periphery debt declined this past fall (even that guaranteed by the EFSF), margin calls occurred. MF Global would have been okay if it hadn’t used so much leverage.

The leverage magnified the margin calls to such an extent that all of the client assets weren’t enough to meet the margin calls. All of the collateral, including the euro debt (at bargain basement prices) and the client assets were sold to offset the borrowings. The clients’ assets are gone. They are not going to be “found.”

Conclusion

No laws appear to have been broken. No one is likely to go to jail. But, as you can see, the financial system is deeply flawed and is rigged in favor of Wall Street and against the ordinary investor. The causes of the financial crisis that appeared in the US in 2009 have not been resolved, only papered over (with money printing). In order to have a “fair” and healthy financial system, the excessive use of leverage, such that success leads to untold wealth for the managers and failure is directly borne by unsuspecting clients or taxpayers, must be changed.  Until this occurs, we will continue to experience such debacles. And the volatility caused by them will continue to keep the financial system unstable and limit economic growth.

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.

December 7, 2011

Severe Europe-Wide Recession Likely for 2012

Posted in Banking, Europe, Finance, Foreign, government, investment advisor, investment banking, investments, sovereign debt, Stocks, taxes tagged , , , , , , , , , , , , , , , , at 8:25 PM by Robert Barone

NEW YORK (TheStreet) — Given the speed at which markets move, and given the volatility that accompanies the hopes and fears that occur when the key European leaders meet to try to make progress on the European debt crisis, it is somewhat risky to try to describe what will happen to the European Monetary Union (EMU) in 2012. Something that I write today, in early December, could be obsolete as early as next week. So, I will approach this with what I consider to ultimately be the most likely scenario, why it is most likely, and where the remaining dangers lie.

There are two opposing forces in Europe regarding the approach that should be taken to resolve the crisis:

  • Those that want the European Central Bank (ECB) to act just like the U.S. Fed and rapidly expand its balance sheet, either to support a strengthened European Financial Stability Facility (EFSF), or directly. The ECB has no mandate in its charter to do this;
  • Those that want the causes of the crisis, overspending and out of control deficits via entitlement and social welfare spending, to be addressed. While these folks appear to be the minority among the political class, their strength lies in the fact that the politicians representing the economically strongest EMU member, Germany, hold this view.

As an aside, some have wondered why the euro has kept its value high vis-à-vis the U.S. dollar. It is precisely because the ECB hasn’t significantly expanded its balance sheet while the U.S. Fed has. In fact, the big worldwide market rally on Nov. 30 due to the “coordinated” central bank policy of insuring liquidity for Europe’s banks, was a “dollar” policy, i.e., dollars, not euros were made available. So far, the ECB appears to have remained faithful to its mandate as the guardian against inflation, and nothing else.

Most Likely Scenario

The U.S. Fed tripled the size of its balance sheet with some apparent success at keeping its financial system from collapsing and, until now, those actions appear to have had no apparent large unintended consequences. There has been some moderate inflation officially reported (and disputed by some), and some believe that the Fed’s balance sheet expansion has been behind the rapid rise in commodity and food prices. But given the apparent success in staving off financial collapse with such policies, the most likely scenario is the first one outlined above, i.e., the use of the ECB or some structure around it (including the EFSF and the International Monetary Fund (IMF)) to directly purchase or partially guarantee the sovereign bonds of the peripheral countries.

>>Saving Euro a Tall Order, Even for Germany

The “bazooka” theory appears to apply here. As long as the market knows that the ECB has a bazooka (the power and authority to print euros), and is willing to use it, it won’t have to. As U.S. Treasury Secretary, Hank Paulson found out in 2009 that the “bazooka” theory doesn’t always work. Time and again, the capital markets have demonstrated that they are much more powerful than any central bank or sovereign treasury.

Verifiable Austerity

The most likely scenario, then, is an emerging consensus in Europe as follows: Through a series of bilateral agreements to avoid having to get 17 separate countries to approve changes to the treaties that govern the EMU, a painstakingly long process, the offending peripheral countries (Italy, Portugal, Spain, and perhaps, Ireland) may agree to some level of verifiable austerity with benchmarks and external audits. In return, Germany and its political allies will permit the ECB to expand its balance sheet either by directly purchasing the sovereign debt of the peripheral countries, or by making credit available to the EFSF or whatever structure emerges.

Once again, as an aside, under this scenario, you can expect the value of the euro to fall relative to other currencies. Of course, if the U.S. Fed embarks on QE3, the euro’s relative value to the dollar may well hold.

Recidivism?

Of course, once the crisis atmosphere passes and things settle down, under this most likely scenario, the peripheral countries may not feel the pressure to continue with their promised austerity. Don’t forget, politics plays a large role and austerity often leads to political defeat for those politicians who negotiated it. Already we have seen political changes in Greece, Italy and Spain as a result of this crisis.

Perhaps these countries will follow Greece’s lead and hire Goldman Sachs to help them issue off the books debt so that they have the appearance of complying with their austerity promises. That could very well buy several years, as it did for Greece. (Ireland appears to be an exception. After their bailout, they appear to have abided by their austerity promises and have made great progress in addressing their fiscal and economic issues. Then, again, none of Ireland’s shores touch the Mediterranean Sea.)

Issues Remain

So, as we enter 2012, the stage is set for some calming over Europe’s sovereign debt and the solvency of Europe’s banks. Mind you, it may be a rocky road over the near term to get there including setbacks and lots of uncertainty and market volatility. The biggest issues will likely revolve around the magnitude of the guarantees and the capacity of the guaranteeing entities. Nevertheless, the most likely scenario is coming into clearer focus.

Unfortunately, this scenario, or any other one that emerges, means recession in Europe, most likely severe recession. This has implications for markets worldwide, as Europe’s economy matches or exceeds the size of the U.S., depending on which countries you include. Once again, the recession, coupled with the austerity measures, may change the political backdrop such that the populations of some of the peripheral countries may well want to exit the EMU.

While 2012 may bring calmer conditions, even if the most likely scenario is executed, the future of the euro and the EMU is still not assured. It rests on the effectiveness of the fiscal controls. If EMU members retain sovereignty over their fiscal policies, then there has to be some mechanism to expel fiscal offenders from the EMU in an orderly manner. Without this, we may well see a replay of this crisis within the decade. Let’s hope there is enough political courage to include such measures.

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 30, 2011

Why Central Banks’ Action Could Make Matters Worse

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Europe, Finance, Foreign, government, investment advisor, investment banking, investments, sovereign debt, Stocks, taxes tagged , , , , , , , , , , , , , , , at 9:47 PM by Robert Barone

NEW YORK (TheStreet) — Over the past 18 months, we have witnessed the emergence of what has become known as the “European Debt Crisis.” Capital markets have become increasingly concerned over the sovereign debt of the European peripheral countries and the solvency of the financial institutions that hold much of that debt. You can tell from the 10-year borrowing rates shown in the table below exactly where the concerns reside.

Solvency issues manifest themselves in liquidity issues. Looking at the table, you can see that investors are hesitant to lend to the lower tier without significant compensation for the credit risk they know they are taking. The solvency issue also plays havoc with the ability of the banks to access the short-term capital markets for their everyday liquidity needs. And, in some cases, especially among the banks in the lower tier countries in the table, those liquidity strains are huge.

If you were a Greek citizen, for example, wouldn’t you go to your bank and withdraw all of the euros you could and put them in your mattress? That is, in order to protect yourself from the prospect of waking up one morning to find that your account was no longer denominated in euro, but in “new drachma” converted on a 1:1 basis, and the free market value of that “new drachma” was such that it took 4 to purchase 1 euro? So, the silent run currently occurring on Greek banks is not surprising.

>>The Real Reason Behind the Central Bank Scramble

A similar phenomenon is beginning to happen to the continent’s banks. This is showing itself in the form of an unwillingness of financial institutions to lend to each other and a severe tightening of the private sector money markets.

So, the coordinated move of the central banks announced today is a reaction to the near shut down of the money markets and it makes liquidity available to the continent’s banks. But, this is not the end of the story because this move only addresses the symptoms (the resulting liquidity issues), not the cause (the solvency issues). As we know in America, the Savings and Loan Industry in the 80s was able to access the money markets in $100,000 increments due to FDIC insurance. As a result, the solvency issues weren’t addressed early when they were relatively small. But, eventually, they had to be dealt with.

Thus, the move by the central banks, by printing money and making it readily available to the banks, only postpones the inevitability of having to solve the solvency issues. It buys time. The tradeoff is twofold:

1) it increases inflationary pressures;

2) it allows the solvency problem to continue to fester, and perhaps, become even worse.

The sovereign nations have two choices: inflation or austerity. They would choose the former except for Germany’s resistance. That story is still being played out. For the banks, significant recapitalizations must occur. We are likely to see a lot more drama played out on this issue, especially if one of the larger institutions has a misstep or is attacked by the marketplace as we saw in the U.S. in 2009.

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 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.

 

October 3, 2011

Kicking the Can: The Issue of Bank Capital

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 10:36 PM by Robert Barone

In the last quarter century, each and every time politicians have “kicked the can down the road” in order to buy time to protect their banks (with the false hope that there will be a “Deus ex Machina,” i.e., a miracle), the resulting pain is much worse than if the problem had been addressed head on and resolved, even if painful at the time.  You can look at this in many ways, including the deficit and entitlement issues in the U.S.  But, I am going to limit myself to the financial realm in this particular essay.

Kick the Can: The S&Ls

In 1984, I gave a presentation to a group of senior citizens regarding what I saw as the insolvency of the S&L industry.  In social conversations, my wife often recalls the reactions of many of those seniors, many of whom had Certificates of Deposit at S&Ls (back then, interest rates were significantly higher than today’s paltry rates).  I suspect that the local heart specialists were busier than usual the next day.

The S&L can was kicked down the road for five more years.  It wasn’t until a new President (Bush #1) was inaugurated that the problem was addressed – that was 1989.  By then, the problem was significantly larger than it was in 1984 when even I could recognize the issue.  Because the can was kicked for five years, America went through an unnecessary and grueling recession in the early ‘90s, in which the financial system teetered and required government intervention.  Truth be told, however, the allowance of the S&Ls to abuse deposit insurance (or at least not appropriately pay for the risk they were layering onto the insurance system) and lack of oversight by the regulators (sound familiar?) should take much of the blame.  However, by ’89 the crisis was addressed, S&Ls were closed, and the bad loans on their books were dealt with.  Because the bad loans were written off, the financial system stabilized and enabled the economy to grow and prosper for much of the rest of the decade.

Kick the Can: Japan’s Banks

At about the same time (1989) Japan’s bubble burst.  In 2002, then Fed Governor Bernanke, criticized the Japanese approach to their banking issues in a famous speech about how the Fed would not let a Japan style deflation happen in the U.S.  Beginning in 1989, the Japanese regulatory agencies did not, and to this day, have not required Japan’s banks to recognize the losses on their underwater real estate loans.  When banks get into a position of knowing they have problem assets, they become quite reluctant to expand their loan portfolios and take on new risk.  Oftentimes, the regulators, recognizing that they have dropped the ball in the first place, become overbearing and shackle the banking system.  More than two lost decades later, Japan’s real estate (land) prices are still falling, and economic growth remains sluggish, intermixed with frequent bouts of recession.

Kick the Can: Too Big To Fail

The financial crisis in the U.S. in ’09 was also met with can kicking.  The “Too Big To Fail” (TBTF) banks that were allowed too much leverage in the period leading up to the crisis were all saved with taxpayer dollars. This time, however, the problems were not met head on as they were in ’89.  In fact, Dodd-Frank has now codified TBTF – those institutions are now called SIFIs, Systemically Important Financial Institutions.  And, America’s banks are back to playing the leverage game, this time with complicity from Washington, which depends on them to purchase newly issued debt.  By the way, that debt requires no underlying capital, an issue we will see later in this essay that has come to the forefront in Europe.  In the ’09 crisis, the shadow banking system (non-deposit taking lenders) was destroyed, and because the remaining small business lenders, America’s community banks, still have major asset issues, small business lending has dried up.  Today, as in Japan, economic growth is sluggish and the economy continuously flirts with recession. (I can’t blame all of the sluggishness in small business lending on the supply side because clearly the demand for small business loans is down due to the uncertain economic outlook that pervades America today.)

Kick the Can: Save the Bondholders

One major mistake of Japan, and of the so-called solution to the ’09 financial crisis, is that bondholders of most of these failing institutions, who took the risk of their investments, have not been asked to take the losses.  Except for FNMA and FHLMC, even the preferred shareholders of the failed megabanks (Wachovia, Washington Mutual, Merrill Lynch) were saved.  Why was it so important to save these stakeholders?  Did we really fall for the concept that if their bondholders lost money, then the economy would totally collapse?

Kick the Can: European Bank Stress Tests

Today, Europe’s banks are teetering on the edge.  This past Spring’s round of “stress tests” were a joke meant only to assuage the markets.  The sovereign foreign holdings of Greek, Irish, Portuguese, Spanish and Italian debt were all counted at par with zero capital required against these assets.  It is clear that the European banks are in desperate need of capital, and the shutting down of calls for such capital from knowledgeable and respected individuals doesn’t really fool anyone.  So, why are the Europeans about to throw good money after bad in a futile attempt to keep Greece from defaulting, and, once again, kicking the can down the road?

By forcing further “austerity” on the Greek economy in order to give them enough aid to pay the upcoming round of bond maturities at par, and therefore “saving” those particular bondholders, they are just prolonging the whole issue.  Even more austerity will further undermine the Greek economy causing ever widening deficits.  So, why are the bondholders so sacred?  The answer, of course, is that the European banks hold huge positions in the sovereign debt of Greece and the other high debt European Monetary Union (EMU) nations.

Kick the Can: Liquefy European Banks

With huge volumes of such debt on their books, each financial institution has become leery of its brethren, and interbank lending has begun to dry up.  As a result, The Fed, the European Central Bank (ECB), the Swiss national Bank, the Bank of England, and the Bank of Japan, in a coordinated effort in mid-September, began making dollar swap lines available to the European banks.  It appears that the Fed is involved because of Bernanke’s view of the Fed as the world’s central bank, and because of the fact that the vast majority of America’s money market funds hold large amounts of European bank commercial paper or other debt as assets.  Thus, instability of the European banking system could potentially touch off another credit market freeze in the U.S. and worldwide.  Yet, despite these interventions, within a week those very same liquidity strains have begun to re-emerge.

Kick the Can: Greek Default Inevitable

In the end, a Greek default is inevitable.  The math on this is too compelling.  Even if Greece could balance their budget pre-debt service, the debt service cost alone, even at reasonable interest rates, doom them to years of depression.  For Greece, default is really the best road.

Default is also better for the rest of the EMU.  Better to use the funds that are now going to pay off bondholders of Greek debt at par to help recapitalize Europe’s banks.  In the long run, this is cheaper and it addresses the underlying issue, European bank capital.

As for Greece, they, and even the other weaker EMU countries, can go back to their own currencies, and, if they so choose, peg them to the Euro.  If they run large fiscal deficits, the pegs can always be adjusted.

Dealing with Greek Default

A Greek default, of course, risks a financial panic in the markets.  To deal with such contagion, the ECB or the EFSF (European Financial Stability Fund) or some pan-European or international entity with credibility, should specify which countries are Tier I EMU countries, which are Tier II (Italy and Spain),and which are Tier III (Greece, Portugal, Ireland).  Tier III countries should be planning an imminent, but orderly, exit from the EMU with ECB and EFSF support of their bonds at some price well below par.   Tier II countries should be given some time and support (in the form of an ECB or the EFSF bond purchase program at par) to get their fiscal houses in order.

The inevitable Greek default is going to have a worldwide impact even if done in an orderly, thoughtful, and coordinated way. (If not planned properly, expect very high volatility in the financial markets.)  And financial institutions in the U.S. will not be spared the effects of such a default.  If the European banks appear in danger, U.S. money market funds, and very likely some of the SIFIs with loans to European banks, will be hard hit by market action.  We have already seen the beginnings of this.

More Capital – the Reason for Basle III

It should be obvious by now that many of the largest worldwide banks need more capital.  Yes, even those in America.  (Consider the recent BAC denial of its need only to obtain capital within a week of the denial!)  The need for capital is why we have Basle III.  Unfortunately, the Basle III timeline is too lengthy, as the capital is needed now.  Without new capital, much of the developed world will suffer the fate that Japan has suffered over the past two decades and now present in the U.S., with banks too worried about capital levels to want to take on additional risk in the form of business loans.  Well-capitalized banks at least remove the constraint of loan availability when conditions are right for economic growth.

Robert Barone, Ph.D.

September 26, 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.

 

September 14, 2011

Proper Policy and 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 10:52 PM by Robert Barone

As indicated in a previous blog post entitled “Why the U.S. Can’t Grow Its Way Out Of Its Budget Jam”, http://www.forbes.com/sites/greatspeculations/2011/09/06/why-the-u-s-cant-grow-its-way-out-of-its-budget-jam/2/ , if GDP growth is as slow as PIMCO’s “new normal” would indicate, then even if the Congress could muster the ‘political courage’ to fix the budget and entitlement issues, lack of growth will trump that effort.  The first issue is that we have a government that doesn’t understand why the economy isn’t growing, and, in fact, promotes policies that inhibit such growth, such as overregulation, interference, and the promotion of more debt as the answer.  The second issue is the structural inability of the economy to grow.  The two issues are closely related.

Policy Gimmicks

Since the Great Recession began (and some believe that it still has not ended) policy makers have used various gimmicks to try to kick start the economic engine.  On the fiscal side, we have seen programs like cash for clunkers or first time homebuyer tax credits that simply have pulled demand forward rather than stimulating new demand.  On the monetary side, Bernanke and the Fed, deathly afraid of “deflation” (we can’t understand why falling prices are worse than rising prices – falling prices make incomes go further, rising prices do the opposite!) have managed, through their policies, to significantly raise the dollar prices of food, energy and related commodities.  Meanwhile, those policies have not halted the significant deflation in housing and its surrounding industries.  From a consumer point of view, the things that they own continue to fall in value, while the things that they need to purchase have risen in cost.  How are they better off after QE1, QE2, and most likely, QE3?

The Key To Growth

One critical issue centers around the level of debt of the American consumer, especially relative to income.  Most of America’s larger corporations have already lowered this ratio and have lots of cash to spend.  Thus, we have witnessed the relatively good performance of the share prices for most of these non-financial entities since 2009.  But the U.S. consumer, without job opportunities, is in a different class.  Demand cannot grow without a healthy consumer.  And, without rising demand, the economy simply stagnates. Some who say they have studied the Great Depression and some commentators today, believe that World War II was the primary factor that pulled America out of depression (see Paul Krugman, “Oh! What a Lovely War!”, New York Times, August 15, 2011).  But think about this: after World War II ended, why would there be an increase in demand?  What had changed? (Yes, there was demand from war torn Europe and Japan.  But I don’t think rational folks would advocate that we destroy assets, our own or those owned by foreigners, so that we can rebuild them.  Don’t forget, when an asset is destroyed, a loss to someone has occurred. If insured, the owners of the insurance company pay; if not, the owners of the property pay.)

Why the Great Depression Ended

The build-up of debt over the 16 years ended in 2008 is similar to the same phenomenon of that occurred in the 1920s.  During World War II, there was rationing and forced saving.  People of that generation often talked about the fact that they couldn’t buy a car, or tires, and that gasoline was rationed. Rationing forced the populace to save and pay down their debt, so that, by the end of the War, the consumers’ debt/income ratios were once again healthy and there was the capacity to increase consumption.  Of course, the rationing caused a huge build-up of pent-up demand.

Table 1 shows consumer debt outstanding for selected years prior to and in the aftermath of the Great Depression.  Table 2 shows a similar growth path in consumer debt and debt as a percentage of GDP from 1992 to 2008.

Table 1 – Consumer Debt, Its Growth Rate, and Its Relationship to GDP

The Great Depression

Year

Consumer Debt

(Billions $)

Periodic

CAGR

Consumer Debt/

GDP

1920

2.964

3.4%

1929

7.116

+10.2%

6.9%

1933

3.885

-14.0%

6.9%

1941

9.172

+11.3%

7.2%

1944

5.500

-15.7%

2.5%

Table 2 – Consumer Debt, Its Growth Rate, and Its Relationship to GDP

The Great Recession

Year

Consumer Debt

(Billions $)

Periodic

CAGR

Consumer Debt/

GDP

1992

799.8

12.6%

2008

2563.7

+7.6%

17.9%

2010

2411.6

-3.0%

16.6%

Note the rapid rise in consumer debt in the 1920s followed by rapid contraction during the initial years of the Great Depression.  Then, debt grew rapidly again until 1941, at which point it contracted rapidly during the war effort due to rationing and the unavailability of consumer goods.  Note that the ratio of consumer debt/GDP was lower in 1944 than it was in 1920.  What had changed during the War was a significant reduction in the indebtedness of the American consumer.

No such rapid consumer debt reductions are evident in the Great Recession, at least not through 2010.  There has been some reduction as shown in Table 2.  But, we believe this is due more to mortgage defaults than to actual consumer debt repayments.  Note the rapid declines in debt in both the 1929-33 and 1941-44 periods.  Reductions of that magnitude are not present in the current economic climate, and some government policies (cash for clunkers, and foreclosure moratoria) discourage debt reduction.  Given what was necessary in the debt area for the consumer to pull the U.S. out of the Great Depression, it appears that we have quite a long way to go in the current environment.

What Policy Can Accomplish

The key to economic growth is rising demand.  This doesn’t happen when existing roads are repaved or unemployment benefits are extended because demand falls back as soon as the road project is finished or the unemployment benefits run out. And, if the funds came from Washington, all we’ve done is raise the level of debt for the sake of current consumption.  If fiscal policy is to be used to stimulate demand, there are several directions it should take.  Today, America suffers from high and rising real costs of energy at a time when real incomes have been stagnant and debt to income ratios have strangled consumption growth.  A fiscal policy that promotes the development of cheap energy now would 1) create jobs, 2) put cash back to America’s consumers via lower gasoline and energy bills, 3) improve America’s balance of trade, and 4) provide less cash to middle-east oil nations and impede their ability to finance terrorism.  We do believe in alternative energy sources when they make sense.  But, the U.S. has an abundance of oil, natural gas, coal, and nuclear technology know how.  Those are the areas that will immediately help the real economy, and, perhaps, reduce the need to send our young people to fight on foreign soil.  Ask yourself why the unemployment rate in North Dakota is 3.3%.  The answer: oil and agriculture.  From 1976 to 2010, Canada’s unemployment rate averaged 8.5%.  In July, it stood at 7.2%.  The reason: Canada has become a major exporter of oil (to the U.S.!) and natural resources.  Consumer confidence there is much higher than similar measures in the U.S.  And its deficit/GDP is half.

Policy Interference

The second way fiscal policy can positively impact U.S. economic growth is to reduce government interference in business.  This isn’t only a federal issue, as state and local governments do their part to harass small business.  But, let’s face facts: the banking system is nearly nationalized with “Too Big To Fail” (now codified in Dodd-Frank as SIFIs -Systemically Important Financial Institutions) allowing the giants to take excessive risk while government regulators strangle the entrepreneurial spirit of most community banks.  For sure, the government is the only real player in the mortgage market through the bankrupt FNMA and FHLMC entities which control 90% of the market (while losing billions of dollars every month).  Additional regulation via Dodd-Frank and the encouragement of and participation in lawsuits against those private companies still in the mortgage business has already, or will soon, reduce private sector participation in mortgages just when the economy needs a recovering housing sector.

Housing Leads

Housing has always led the economy into recession.  But, it has always led it out.  Not this time.  The mortgage pendulum has swung from one extreme (breathing qualified one for a 125% LTV mortgage) to the other (huge down payments, high income/payment ratios, and a near universal requirement to qualify for sale to FNMA or FHLMC, which, as of October 1 will have lower maximum loan acceptance levels).  The promotion of a universal mortgage refinance idea being bandied around Washington may stimulate some demand as consumers who get lower rates and payments may have more monthly disposable income, but what has been forgotten, or conveniently not discussed, is the loss of that cash flow to the investors who own the mortgage instruments.  In other words, this is just an income redistribution scheme which may not produce many jobs because the owners of the now lower yielding mortgage paper are more than likely the job creating entrepreneurs.  The real issue here is the continued downward spiral of home prices.  The policies followed in Washington have simply prolonged the pain.

Tax Code Gibberish

The personal income of one of the authors is derived from wages and consulting income.  Yet, his tax return is more than an inch thick, costs $1,500 to produce, and is a maze of incomprehensible gibberish.  This is symptomatic of the unnecessary and burdensome set of rules that the federal government has imposed on its citizenry.  Because Dodd-Frank and the Obamacare legislation have yet to be fully implemented, we can expect higher costs and more job killing rules and regulations.

The Private Sector Creates jobs

The real creation of jobs occurs in the private sector, by the private sector, not in government or by government.  Policy can encourage or discourage such job creation.  More than any other era in our lifetimes, government policy has discouraged private sector job creation.  Today, like in the 1930s, consumers need to reduce their debt burdens.  Policy cannot do this directly.  The gimmicks used thus far have pulled demand forward, have taken from one set of citizens and given to another, have increased the debt which will reduce future consumption, or have inflated food and energy prices via money creation.

However, proper policies can encourage economic growth.  Unfortunately, there is no “instant” cure.  Equally unfortunate, a Presidential election is but 14 months away, and that “instant” cure is what is being sought.  What America needs are policies that encourage and promote cheap energy, reduce government regulation, a complete reformation of the tax code, and the encouragement of debt reduction all while addressing spending and entitlements.  The track record in Washington to accomplish this is nil.  It’s no wonder that the price of gold continues its ever upward path.

Robert Barone, Ph.D.

Matt Marcewicz

September 12, 2011

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