November, Friday 04, 2011

DOW – 61 = 11983
SPX – 7 = 1253
NAS – 11 = 2686
10 YR YLD -=2.05%
OIL - .45 = 93.62
GOLD – 10.40 = 1755.00
SILV - .35 = 34.23
PLAT unch = 1637.00

What is the single most important thing in the economy today?

(clip) No it’s not Kim Kardashian’s divorce, even though that story topped the news cycle this week.

When we’re talking about the economy (clip) we’re talking about jobs. So, how’s that working out?

The economy gained 80,000 jobs in October, with the jobless rate falling to 9.0% from 9.1%. Government revisions showed that an additional 102,000 jobs were created in September an August. Maybe we should make a few new jobs for people who count jobs.

Inflation adjusted wages fell 2.4% in the third quarter. The U6 unemployment rate dropped from 16.5% to 16.2%. The U6 number includes people who work part-time to scrape by and people who have been out of work for so long they don’t get counted in the headline numbers.

Job gains were reported in business services; apparently call centers are doing a booming business, as wages in Iowa are now more competitive with wages in India. Also, jobs were added in the leisure and hospitality sector. But the biggest jobs gains came from adjustments in the birth/death method of counting jobs.

In 2001, the Bureau of Labor Stats started to compensate for the tendency to miss new business formation. Previously, BLS tended to under report new jobs in the beginning of a cycle turn. What the new B/D Adjustment series did was take new incorporation filings per state, and deduce from them that new jobs were being created. The problem with this method of counting is when the economy is contracting and firms go out of business, the counting gets messed up. For example, say you have an incorporated firm that employs 100 people, and it goes out of business. And let’s say two of those people who lost jobs incorporate to form two new shops. Based on the Birth Death Adjustment – the economy added jobs.

It turns out that 42% of all the jobs created in America over the past year are due to this type of magical counting. If you take away the stupid accounting, more people might realize the serious nature of our current economic situation. We might get more than lip service to crating jobs.

But today’s jobs report was just a lead-in to the news out of Europe. Greek Prime Minister George Papandreou canceled a referendum vote on Greece’s latest bailout package; a vote that could have gone either way, depending on a variety of factors; the big loser is democracy.

Now there is a confidence vote ……It is almost irrelevant. Papandreou is almost certainly finished. He will be voted out or he will resign. The new government will almost certainly approve a bailout plan.

(Greek Prime Minister George Papandreou said Friday he will begin talks aimed at creating a new coalition government that will approve a bailout package for the debt-strapped country, according to reports. Papandreou, before a confidence vote got underway, outlined to parliament his idea of talking to all parties about forming a new coalition. European leaders, along with global equity markets, were rocked earlier this week by Papandreou's unexpected proposal for a referendum on a bailout package the Greek government had previously worked out with the European Union. Papandreou later dropped his push for a referendum. )

Either way, Greece is insolvent; Italy, Spain, and Portugal are wobbly; the Euro is in doubt; and the USSA won’t go unscathed.

So, let’s look at the magical accounting that got us into the current situation.  We can start with the Basel Accords, which established a framework for capital requirements. The basic idea was that all sovereign debt in Europe was “risk free”.

In the past five years or so, Eruopean bank regulators have demanded that banks raise their holdings of liquid, safe assets following the subprime credit crunch. Those safe assets that the banks were required to hold – mainly government bonds that carried zero risk.

This past summer, European bank regulators conducted stress tests. The banks were not required to make any allowance for writing down sovereign debt in the financial simulations – because the sovereign debt was considered zero-risk. The banks passed the stress tests.

Working on the assumption that sovereign debt was zero-risk the Eurozone countries issued much more debt than they might have otherwise, and they issued it at the cheapest rates possible. In other words, it was all mis-priced.

So what does recent history tell us about what happens when securities are mis-priced?  Well,  you may remember a few years ago when mortgage lenders in the USSA were running ads saying “No job, no documents, no problem!” The only requirement for a mortgage was the ability to fog a mirror; those mortgages were then bundled into securities; the ratings agencies were bribed and they assigned Triple A ratings – which meant that these Mortgage backed Securities were super safe.

This mis-pricing made it really easy to sell these securities and allowed many financial institutions to purchase these securities, comfortable and confident that they were holding the highest quality and safest securities. Then a couple of little hedge funds went bust trading these super safe, Triple-A subprime securities. Then bear Stearns and Lehman brothers lost money; and then everybody realized they didn’t have a clear understanding of what they held and there was a huge credit freeze.

Fast forward to today. Greece is headed for default and forcing holders of sovereign debt to take voluntary haircuts or losses of 50% or more on their bonds – you know the same bonds that everybody has been pricing at zero-risk. And that means we have to make adjustments to our assumptions about risk.

We know that Greek bonds are not just risky – they are essentially worthless – and then we have to reconsider all sovereign debt. 

The consequences? Well banks would need to raise more capital; that would mean less lending; central banks would have to change how they conduct money market operations; they would have to impose tougher haircuts, not just for bad bonds but also for potentially bad bonds.

It gets worse.

Since sovereign debt was considered zero-risk there was no need for sovereign entities to post collateral for derivatives. So the mis-priced securities mean the derivatives are mis-priced. And the IMF estimates the under-collateralization problem is about $1.5 trillion to $2 trillion dollars for the 10 largest banks alone.

It turns out that Europe is subprime on steroids.

Greece has already defaulted. Some people are now claiming the market has already priced in the Greek default – I don’t think so, because when Greece goes down, the next in line is Italy. And then we’re looking at a Lehman Brothers moment – everything freezes. Today, the yields on Italian bonds climbed to the highest levels since the formation of the Euro – that’s not a sign of confidence.

And so today, the IMF put up a fire-ring around Italy. The IMF will oversee Italian reforms. What happens when you give up a little sovereignty for the sake of security?

Well, we’re going to find out.

But the IMF taking over Italy really means is that the contagion has started.

There is another option. Europe could truly unite, with the support of the major economies of the world; they could come together, they could pull together.

The G-20 is meeting in Cannes, France. You’ve heard of Cannes, the home of the annual film festival. I think all the G-20 will be screening the new Leonardo d’Caprio movie tomorrow. So far they haven’t done anything, except to agree they won’t be writing any checks for Europe – at least until they see some details.

This crisis has been unfolding for over a year. No one has stepped up to solve the problem, and after a year, it is unlikely anyone will step up to fill the leadership vacuum. Perhaps what we are learning is that it is not a lack of a charismatic leader to solve our problems. Perhaps we are starting to learn that the problems are systemic, and if the foundation is rotten, the building will eventually crumble. When debt grows to a certain level, it simply can’t be repaid and default becomes inevitable. And what we are seeing is that the debt in Europe has been mis-priced and it is worse than previously imagined. There will be pain, the big question is who will feel it most.

When Lehman filed for bankruptcy in that fateful week of September 2008, one thing caught everyone's attention: the epic surge in the Fed Reverse Repos originated by "foreign official and international accounts": essentially cash placed at the Fed by foreign institutions in exchange for collateral, primarily in the form of Treasurys, as well as other securities. This is nothing but an immediate cash parking in a 'safe place', which withdraws overall liquidity from the market, and as has been noted elsewhere, serves as an indirect gauge of banking system funding stress. In the week of September 24, this number soared from $46.6 to $93.7 billion, a $44 billion increase, or the single biggest jump in the history of the series. Well, as the chart below demonstrates, what happened with MF Global caught foreign banks, which as we have noted over the past several weeks have been dumping US Treasury and MBS paper, entirely by surprise as they scrambled to withdraw the last traces of available liquidity from the market, and to place as much of it as possible within the safety (and we use the term loosely) of the Fed. In the just released H.4.1 update, foreign Reverse Repos with the Fed soared from $81.3 billion to $124.5 billion, the most ever, and a weekly surge of $43.2 billion, the second largest ever, second only to the Lehman collapse. Furthermore, as noted daily, European banks have been doing precisely that with local cash from non-US subsidiaries, and parking near record amounts with the ECB (today the European central bank disclosed awhopping €253 billion had been deposited with it: just shy of the 2011 high), even as they have been dumping US Treasurys on one hand, and now are forced to repo what little paper they have left with the Fed due to systemic uncertainties in the MF aftermath, one can see why suddenly there was absolutely no liquidity left in the market, and why the meager €3 billion EFSF bond offering, so desperately needed to fund the ongoing Irish bailout and which incidentally is the story of the week, had to be pulled.