Friday, March 08, 2013 - Jobs Report and Bad Banks

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Jobs Report and Bad Banks

DOW + 67 = 14, 397
SPX + 6 = 1551
NAS + 12 = 3244
10 YR YLD +.07 = 2.06%
OIL + .29 = 91.85
GOLD + .60 = 1580.20
SILV + .12 = 29.10

The Dow Industrial hit their fourth consecutive record high close. The S&P 500 is within 1% of record highs. The S&P is up for 6 straight days, and 9 out of the past 10 weeks. Year to date, the Dow is up 9.9 percent, while the S&P 500 is up 8.8 percent and the Nasdaq is up about 7.5 percent.

The economy added 236,000 jobs in February. The unemployment rate fell from 7.9% to 7.7%. The number of jobs gained beat expectations by about 76,000. The unemployment rate is now at its lowest level since December of 2008. Part of the reason for the drop in the unemployment rate is that fewer people are counted as being in the labor pool, looking for a job; this is known as the participation rate and it dropped to 63.5%, matching a 32 year low.

Still, this was a much stronger jobs report than we've seen in a while. There was improvement, but not enough. We haven't yet seen the dramatic upswing that leads to a virtuous cycle of growth and truly low unemployment.

The report showed that virtually every sector added jobs with the exception of government. The public-sector workforce has been shrinking for four years, and last month another 10,000 jobs were lost. Most of the state and local government layoffs are over, however state and local government employment is still trending down. Of course, the Federal government layoffs are ongoing with many more layoffs expected due to the sequestration spending cuts.

Construction added 48,000 jobs; similar ongoing gains in construction are not likely. The biggest increases in hiring occurred in professional services, with 73,000 new jobs, health care added 32,000 and retail added 24,000 jobs. The economy has added an average of 205,000 jobs over the past four months, up from 154,000 in late summer.

The U-6 unemployment rate is an even higher 14.3%; U-6 includes people who have gotten too discouraged to look for a job or who can only find part-time work; by that measure; 22.6 million Americans remain out of work or underutilized, including 8 million people working part-time and nearly 5 million who have been without a job for at least six months. About 40% of unemployed people have been out of work longer than six months, far more than at any time since the Great Depression. Many of those people will not work again. For statistical purposes the long-term unemployed stop getting counted. Some of those people are retiring as the boomer generation grays; sometimes the retirement is voluntary, more likely not.

The 55- to 64 age group is the fastest growing group of entrepreneurs. The 20 to 34 age group has the lowest level of entrepreneurship. There are a couple of factors at work here. First, there is a tendency to hire younger workers; they cost less; and so younger workers find it easier to take a traditional job. For a young worker, with a mountain load of student loan debt, the traditional job might make sense. We know that boomers have been opting for or forced into self-employment. Older workers have experience and some have managed to save enough to launch a self-employed career. Further, some have reached the age where they are eligible for Medicare, and no longer have to worry about being tied to the company store's health care plan.

Some people equate innovation and creativity with youth. Bill Gates would probably have a hard time getting a regular job in Silicon Valley today. But with age comes experience and competency, and perhaps a confidence to think outside the box. Of course, if the labor pool gets shallow, many self-employed would jump back in.

Back to the jobs report; while it looked like a solid report, we are still not seeing enough new jobs. The population growth suggests we need 165,000 new jobs per month just to stand still. That means the improvement in the unemployment rate is largely the result of people leaving the workforce. Average hourly earnings, meanwhile, climbed 4 cents, or 0.2%, to $23.82 in February. They are up 2.1% over the past 12 months, just slightly faster than the pace of inflation. The workweek edged up 0.1 hour to 34.5; it usually rises when the economy gets stronger.

So, the headline numbers: 236,000 new jobs; unemployment drops to 7.7%; that is good news, but we still have a bad labor market.

Now, I refer you to Federal Reserve Chairman Bernanke's recent testimony before Congress. After talking about the threat of deflation, Bernanke said: “our accommodative monetary policy has not really traded off one of [the FOMC’s mandated goals] against the other, and it has supported both real growth and employment and kept inflation close to our target.”

There is nothing in today's jobs report to indicate the Fed would step away from QE. Bernanke and Fed Vice Chair Janet Yellen have gone to pains to persuade investors that they want to see the economy attain “escape velocity” before they move toward tighter policy. And most of the Fed's monetary actions take time to be felt, but any hint of an exit from free money would likely trigger a negative and immediate reaction. So, the Fed will sit back and stay quite on this report.

Yesterday, we learned the results of the first part of a two part stress test for the 18 biggest US banks. Only one bank failed the test: Ally only had 1.5% in capital set aside under a measure known as Tier 1 common ratio, which compares the bank’s common equity to its risk-weighted assets. That is significantly below the generally accepted standard of 5%. In other words, they didn't have a cash cushion for tough times. So, Ally Financial, which by the way is still 74% owned by us taxpayers, was the only bank to fail. The other 17 institutions fared better, but many experienced major mortgage, securities and loan losses under the recession scenario.

Of course, the results are based on the banks' reported figures, which don't always jibe with the Federal Reserve's numbers. For example, Wells Fargo reported much higher reserves. Goldman Sachs could theoretically lose $25 billion in trading losses under the stress test; no problem; they passed. JPMorgan reported higher numbers than the Fed figured. Goldman Sachs gave itself enough reserves to pass the test; the Fed's numbers would have resulted in a failing score. What this really tells us is that the banks still have a fair amount of toxic assets on the books.

Of course, there are quite a few people who are arguing the stress tests were way too lenient; they underestimated the potential losses, and the effects of a global financial meltdown which can paralyze the entire system, as Hank Paulson would say. And even under the test, the worst case scenario is that the banks would lose $462 billion, but nobody would panic. Everything would just roll merrily along. And the test didn't look at a possible increase in interest rates, which might represent a much bigger risk to the banks.

It's kind of like preparing for crossing Death Valley in July. You have a nice cold can of Coca-Cola, you're good to go; you pass the preparedness test.. Actually, the test is really about the ability of banks to pay dividends and buyback stock in order to prop up share price, in order to boost executive bonuses.

Next week, the Fed will release another series of stress test results which will determine whether the banks can pay dividends to shareholders of can buyback shares. Citigroup has already announced a share $1.2 billion in buybacks. Last year, the Fed passed most of the big banks and let them pay out billions. Bank of America, sensing a request would be unwelcome, didn’t even ask. This year, however, Bank of America will likely get the green light. BofA passed yesterday's stress test, despite having set aside very little for legal reserves. And BofA is facing some lawsuits that could cost tens of billions.

The dispute involves a 2011 settlement that BofA reached with some very big investors. The settlement was for $8.5 billion to cover up to $100 billion in losses on bad Countrywide loans. In other words, they settled for pennies on the dollar. Now, there is a suit alleging a breach of fiduciary duty by the trustee that accepted the settlement; if that is found to be the case, the settlement could easily rise to more than $25 billion.

A look at Bank of America’s estimates for how much it will have to pay for its mortgage liability is telling. It has gone up steadily each year. In 2009, the bank had a reserve of $3.5 billion. By last year, it had jumped to $19 billion, with an estimate of additional loss of up to another $4 billion. And so Bank of America seems to have been consistently underestimating its legal exposure. In keeping the reserves low, Bank of America has already won. If it turns out that the bank loses its cases and has to pay much more money, it nevertheless has managed to make its books look that much better for years. It's a risky move, and for now, the regulators are giving them a pass. Time will tell what the courts will do.

Also, next week we are scheduled to read the Senate Permanent Subcommittee on Investigations report on the London Whale. We expect the report will show senior executives at JPMorgan were very much aware of the Whale's trades and played a role in allowing the CIO trading desk to build bets without fully warning regulators and investors.

A BBC article exposed another risk in the banking sector: technology. We've heard lots of stories about financial innovation over the years but it turns out the banks don't have much respect for technology. The problem grows when there have been acquisitions. The transition from two systems to one system can take years, and can result in significant overlap; multiple mortgage systems, 50 or more, when one or two would get the job done.

Another factor that can mess up IT integration is a difference in cultures. For instance, believe it or not, Countrywide’s prize asset was its servicing platform, software it had developed internally. But Bank of America didn’t like or do custom, it relied as much as possible on vendor-provided software. It proceeded to upload its customer data and integrate stray systems into the Countrywide platform, and then manage it like a BofA installation, which resulted in it losing the specialists who knew the systems

Most IT applications carry around dead code – which lies dormant because none of the live modules are using it. When Knight Capital ran an update in its systems, some of the dead code was brought back to life, causing the system to spit out incorrect trades.

By the way, the BBC article was in response to an IT crash at a British bank, NatWest, which left customers unable to withdraw cash, pay for goods or services, or carry out online banking. But don't worry, it can't happen here.