Wednesday, June 05, 2013 - Agree to Disagree

Agree to Disagree

by Sinclair Noe

DOW – 216 = 14,960
SPX – 22 = 1608
NAS  - 43 = 3401

10 YR YLD 0 .03 = 2.10%
OIL + .38 = 93.69
GOLD + 2.70 = 1403.70
SILV unch = 22.65

The big economic news this week will be the Friday morning jobs report. ADP, the payroll processing company does its own jobs report, and today they estimated the economy added 119,000 new jobs in May. The ADP report is not a good indicator of Friday's report, but taken on its own, today's analysis shows a softening labor market, dragged down by the sequester.

Then, this afternoon we read the Federal Reserve Beige Book; here's how they described things:

“Overall economic activity increased at a modest to moderate pace since the previous report across all Federal Reserve Districts except the Dallas District, which reported strong economic growth. The manufacturing sector expanded in most Districts since the previous Beige Book. Most Districts noted slight to moderate gains in consumer spending and a moderate increase in vehicle sales. Tourism showed signs of strength in several Districts. A wide variety of business services expanded, and transportation traffic increased for producer, consumer, and trade goods. Residential real estate and construction activity increased at a moderate to strong pace in all Districts. Commercial real estate and construction activity grew at a modest to moderate pace in most Districts.”

And fade to beige, actually a modest to moderate shade of beige. After reading the Beige Book, I know what you're probably thinking; yes, it is properly titled. I really don't think we need to spend more time on that report because it's pretty obvious the Fed didn't spend much time on the report. Yes, we should all pitch in to send them a thesaurus.

You'll notice that the Federal Reserve did not use words like: fantastic, robust, overheated, exuberant, or even copacetic. I've been trying to tell you that there is a disconnect between the economy and the stock market.

Part of the problem is the Fed lives in a land of make believe and isolation. This week, Federal Reserve Governor Sarah Bloom Raskin was speaking on a panel at a conference on joblessness. Seems she left her ivory tower and went to a job fair in her hometown and she was shocked to find that most of the jobs were for security guards, restaurant workers and even life guards.

So, she  investigated the type of jobs that have been gained since the economy emerged from recession. She found half of all those hired received low pay jobs, but two-thirds of the jobs lost in the recession were middle income jobs like factory and construction workers. Ms. Raskin said she is concerned about “the quality of jobs available.”

The low quality of jobs added in the recovery explains why wages have mostly stagnated even while unemployment has declined in recent years. Ms. Raskin said the phenomenon suggests there is a disconnect between education and the skills employers need; which may be partially true, but also demonstrates the need for Ms. Raskin to get out a little more.

She also said the current unemployment rate, which still remains high despite its gradual improvement, underestimates the true scope of the unemployment problem. And she said the “real risk” of long-term unemployment is that the longer a worker stays unemployed, the more unemployable they grow. Firms are increasingly reluctant to hire people who have been out of the workforce for long stretches, which leads to those workers losing skills and ultimately the ability to ever reenter the workforce.

She didn't talk about monetary policy.

The SEC has come up with a proposal to make sure the money market fund industry doesn't “break the buck” again. The funds would be required to fundamentally change how it prices its shares in an effort to reduce the risk of abrupt withdrawals, also know as a run. You'll love this; the idea to stop a run on the funds is to charge withdrawal fees and delay the return of funds to customers in times of financial distress.

In other words, once the money market funds get their hands on your money, it's not really your money anymore, it's their money and you don't have much say.

In 2008, the Reserve Primary Fund, one of the largest money funds, suffered losses on Lehman Brothers debt and could not maintain its $1 per share price, known as "breaking the buck." That ignited a run by investors across the money fund industry, cutting off a major source of overnight funding for many corporations. I remember talking about that with you, and telling you back then that there was a real problem.

In 2010, the SEC adopted rules that bolstered fund transparency, tightened credit quality standards, shortened the maturities of fund investments and imposed a new liquidity requirement.  For years, proponents of further reform have raised concerns that money market funds, mutual funds that invest in short-term debt securities, can be considered as safe as bank deposits even though they do not have a government guarantee.

In a compromise move, the SEC's plan mostly focuses on prime funds for institutional investors, which are seen as more prone to runs because those investors are more sophisticated and more likely to pull large blocks of money first if there is a panic.

The SEC estimated that institutional funds represent 37 percent of the market with $1 trillion in assets. The SEC's plan calls for two alternative proposals that it said could be adopted alone or in combination.

The first piece would require prime funds used by institutional investors to transition from a stable, $1 per share, to a floating net asset value (NAV) - a move designed to reduce the risk of runs like those during the financial crisis. The SEC said that retail and government funds, which are not considered to be at the same risk for runs, would not have to move to a floating NAV. That one dollar price seems appealing even if it is not an accurate price of the net asset value. It's smoke and mirrors and a big pile of garbage, but it gives the illusion of stability.

The second proposal, meanwhile, would give fund boards for institutional and retail funds the authority to impose so-called "liquidity fees and redemption gates" during times of stress. That would give funds the power to stop an outflow of investor money.

Goldman Sachs wants you to believe that Too Big To Fail banks do not actually enjoy a funding advantage. Goldman put out a paper with the mild title of "Measuring the TBTF effect on bond pricing." It argues that the commonly-held view that TBTF banks can borrow cheaply because bond investors expect the government will support them used to be a little bit correct. Then it became very correct during the financial crisis. But now is totally incorrect.

The study argues that that six banks with more than $500 billion in assets paid interest rates on their bonds that were an average six basis-points lower than smaller banks from 1999 to mid-2007. When the financial crisis struck, the funding advantage grew far wider. But beginning in 2011, the funding difference reversed, with the biggest banks now paying an average of 10 basis points more than smaller banks.

It sounds like a good argument but it isn't exactly true. The TBTF funding has never been about absolute funding levels of big banks or even the funding levels of big banks relative to smaller banks, rather it is that the big banks get government support that lowers the cost of funds compared to what they should be.

Goldman has much lower capital reserves, or a cushion to protect against bad bets, and they tend to bet much bigger, therefore they should be paying a significant premium for capital. They don't. So, there is a TBTF subsidy. It's not as large as it once was, probably because the financial crisis made it clear that the largest financial institutions are far more fragile than almost anyone suspected prior to 2008. But it's there and plain enough to see.

It's a bit disturbing that Goldman doesn't seem to understand this. Their misperception means that they are likely to misread or ignore market signals about the risks they take. Goldman—and the other TBTF banks—seem to still be blind to their own vulnerability—which is what got us in the financial crisis mess in the first place.

Tomorrow, the International Monetary Fund is expected to issue a report on Greece, a mea culpa, or as they describe it: In an internal document marked “strictly confidential,” the IMF said it badly underestimated the damage that its prescriptions of austerity would do to Greece’s economy, which has been mired in recession for years.

Seems the IMF ignored its own criteria for qualification, then maybe decided Greece should not have been eligible for assistance, then they thought Greek debt was sustainable, then they thought the Greeks would cut all government spending, then they realized that couldn't happen, but then they decided to hold the Greeks for ransom until they cut more than they could, then they wondered why the economy didn't respond like they hoped, then they postponed the restructuring for 2 years because they were worried the Greeks couldn't be trusted with a new credit card, then that made everything more expensive for the Greeks, then they didn't count very well, then they failed to identify growth enhancing structural reforms, and all the IMF mistakes didn't help Greece, but it did help the wider Eurozone and especially the Euro-banks, and the whole country just went down the toilet and it's a crying shame, and oopsie, the IMF is sorry about that, but now they conducted a study and determined that despite all those things that might seem on the surface to be IMF mistakes, in the end, it was the Greek government that is to blame.