March, Monday 26, 2012

DOW + 160 = 13,241
SPX + 19 = 1416
NAS + 54 = 3122
10 YR YLD +.01 = 2.24%
OIL + .08 = 107.11
GOLD + 27.10 = 1690.90
SILV +.60 = 32.94
PLAT + 1.36 = 22.00

Last week was the worst week of 2012 for the S&P 500. No big collapse last week, just a down week. The S&P 500 is still up 25% since the end of September. We have a nice bull market, likely a cyclical bull underway, and with good reason. We've seen some improvement in the economy; the unemployment rate has been moving lower; economic activity has picked up in the manufacturing and services sectors; central banks have been shoveling money out of helicopters from Athens to Rome to New York. C'est si bon! Let the good times roll.

Of course, you probably remember the almost total collapse and meltdown of the global financial system a few years back and you might be wondering what was done to correct the malinvestment; and the answer is nothing. Everything is still as screwed up as ever; nothing was fixed. And then you remember that even though we have this nice cyclical bull market, we are still in a secular bear, at least for now; and that means the recovery is perilous at best.

Fed chairman Ben Bernanke gave a speech today and he basically said we're not out of the woods just yet. Bernanke said he’s encouraged by the unemployment rate’s decline to 8.3 percent, continued accommodative monetary policy will be needed to make further progress. The drop in unemployment may reflect “a reversal of the unusually large layoffs that occurred” in 2008 and 2009, and this process may now be over.“A wide range of indicators suggests that the job market has been improving, which is a welcome development indeed. Still, conditions remain far from normal, as shown, for example, by the high level of long-term unemployment and the fact that jobs and hours worked remain well below pre-crisis peaks, even without adjusting for growth in the labor force. ”  Reducing the jobless rate further will probably require a quicker expansion of business production and consumer demand, which “can be supported by continued accommodative policies.”

Now, let's look back to this cyclical bull market that has been pushing stocks higher since the end of September. Remember what happened back then? The Federal Reserve was announcing Operation Twist, which was really just another name for Quantitative Easing Part 3, and over in Europe the European Central Bank announced the LTRO, the Long Term Refinance Operations, which were at least partly backed by the Federal Reserve dollar swaps, which was really just another name for Quantitative Easing Part 3 with subtitles.

When we look in the Federal Reserve's toolbox we see that they have interest rates at zero, so they can't do much there – and that leaves Quantitative Easing. Notice that Bernanke said business production and consumer demand “can be supported by continued accommodative policies.”  Continued accommodative policies; this has been going on for quite some time. This is not a surprise..., and still, the markets just love to hear that the Fed is passing out free money.

The Federal Reserve faces a multi-year deleveraging process and the tools available to them are not up to the challenge. So, part of what they're doing is policy experimentation. For example, the housing market remains a mess and there is little structural improvement. Just a few years ago, we went through a process of easy credit and leverage of debt. People borrowed beyond their incomes, banks loaned without concern, and many companies got in on the credit entitlement gravy train.

Three years ago, the Fed intervened in the markets to try to avoid a disorderly implosion; which they accomplished in a fashion. They did not prevent the beginning of a deleveraging depression but they managed to put lipstick on the pig. They did this by putting their own balance sheet into the system to compensate for deleveraging. The result is that the Fed's balance sheet is now contaminated and they are now forced to continue QE or else the toxic assets on their own balance sheet are likely to implode.

What does this mean to you?

Well, let's do the math. The Dow Industrials have basically doubled in the past 3 years; the S&P 500 is up 25% since the end of September. Treasuries have seen a little slump in prices and the yield on the 10 year note popped to a little over 2.3% but the Fed will likely work to prevent yields moving to 2.5% - so flat, to slightly lower yields moving forward. The range is 1.9% to 2.5% on the ten year. Gold has doubled in the past 3 years and it is still in one of the nicest long term uptrends you will find. So, a trend in place is more likely to continue than it is to reverse.

Until it reverses.

Yes, there is fruit on the tree, ready to be plucked, but it is out on the limb. The structural problems have not been corrected. The failure to allow deleveraging in 2009 means that pressure has built up. The global financial system is as perilous as ever. The cyclical bull market could flop in a heartbeat. As always, in a deleveraging situation, there will be opportunities.

Europe’s banking sector holds 2½ times as many assets as the U.S. banking sector. It’s huge. And it’s in big trouble. Europe’s banking sector needs cash — mountains of cash. As a result, it will have to sell more than $1.8 trillion of assets, which will likely take a decade to work through. For perspective, it sold only $97 billion from 2003–10.

Banks can’t really hold bad debts for long. As soon as they report a big bad debt on a quarterly financial statement, some annoying things happen. It means they have to put aside more capital for this particular loan, which they hate to do, as it lowers profitability and requires a lot of paperwork. It can raise the attention of regulators, which banks hate. It can raise shareholder suspicions about lending practices, which banks hate. So the usual way to deal with bad debts is to clear ’em out as fast as possible. (Unless you’re swamped with bad debts in a full-blown crisis, in which case you try to bleed them out and buy time to earn your way out, and/or patch them up as best you can to keep up appearances while you pray for a miracle — or a bailout.)

What else do we know? Well, we know that the Fed is terrible when it comes to forecasting the economy, which is why they are now pushing on a string with their Zero Interest Rate Policy; the Fed was buying toxic assets when prices were still high, and now their balance sheet is contaminated with the garbage. They will push the markets higher, but you need to remain nimble.

Two weeks ago, the government disclosed that it is looking into bringing criminal cases against traders and banks that manipulated a key bank lending rate, called LIBOR. A source close to the case says the government's "may" will be dropped soon. Both Barclays and Deutsche Bank have disclosed that they have been the focus of investigations. Banks have suspended dozens of traders. Today, Credit Suisse announced that it was cooperating with regulators on the case. Traders at UBS reportedly are already working with the government on its investigation.

Consider what went on here. Banks took a rate that they artificially set themselves, and then went out and convinced municipalities and pension funds and others to bet against them on the rate. LIBOR rates were supposed to be set by bank treasurers reflecting what it cost them to borrow from other banks. But reportedly a number of bank treasurers consulted traders when deciding what rate to report to the organization in London that collected and posted the rates.

What's more, traders at a number of banks were given access to the systems that bank officials used to enter the rate so they could overwrite the rates with ones that would better suit them. When the rate went the way Wall Street traders programed it to do, the banks cashed in millions.

The LIBOR rate also affects what many of us pay on our adjustable mortgage, home equity loans, car loans and others. But that is a little bit of an aside. The real, clear damage is in the contracts that banks set up with municipalities and others to bet on their own manipulated rates. Baltimore was sold as much as $300 million in LIBOR contracts. The city is the lead plaintiff in the class action against the banks. The suits say the LIBOR market is as large as $90 trillion. Though some have put the market of things the rates affects as much as $350 trillion in loans and derivatives. The suit says on average over the period it was manipulated the banks artificially held the LIBOR rate down by 0.87%. Go with the smaller figure and by back of the envelope math, you get that the banks could have made as much as $750 billion on their scheme, but it probably wasn't that much since banks were probably asked to long and short on the rate.

The case apparently doesn't involve Goldman Sachs but it is clear that we are all Muppets now.

Securities regulators accused Wells Fargo  of repeatedly ignoring its subpoenas for documents in connection with a probe into the bank's $60 billion sale of mortgage-backed securities. The Securities and Exchange Commission's filing in a San Francisco federal court seeks to compel the Wells Fargo to hand over documents. The SEC said it has issued several subpoenas since September.

The SEC is looking into whether Wells Fargo made "material misrepresentations or omitted material facts" in offerings it made to investors from September 2006 through early 2008.  The SEC charges that a due diligence review of a sampling of the securitized loans was done, and some of those loans would be dropped because they failed to meet the bank's underwriting standards. But the regulator said it "does not appear that Wells Fargo took any steps to address similar deficiencies in the remainder of the loans in the pool, which were securitized and sold to investors."

According to the SEC's Friday filing against Wells Fargo, the agency has issued six subpoenas to Wells Fargo since September 30.  Among the types of documents the SEC is seeking are loan underwriting guidelines, due diligence reports, drafts of prospectus supplements, staff training materials, preliminary loan data and 1,365 emails.

Just in case you're wondering why we still have structural and systemic problems with the economy. This is it.

The Center for Public Integrity, a Washington based nonprofit has ranked New Jersey as the state with the lowest corruption risk in the country. Apparently there is a fine but discernible line between “corruption risk” and “actual corruption”. When asked how New Jersey won the top ranking, an official from the Center said, “They made us an offer we couldn't refuse.” I'm not quite sure which metrics were used to determine corruption risk but I think it says something really, really bad about the other 49 states.