Wednesday, May 07, 2014 - On the Mend, Not Too Big, No Reason to Jail; Not Exactly

On the Mend, Not Too Big, No Reason to Jail; Not Exactly

by Sinclair Noe

DOW + 117 = 16,518
SPX + 10 = 1878
NAS – 13 = 4067
10 YR YLD un = 2.59%
OIL  + 1.35 = 100.85
GOLD – 18.00 = 1290.90
SILV - .25 = 19.40

Federal Reserve Chairwoman Janet Yellen testified before the congressional Joint Economic Committee today. Here’s the quick summary: taper from QE is on track, after the Fed exits QE asset purchases they will look at the possibility of raising interest rates – maybe 2015 or 2016, they will hold almost all of the mortgage backed securities they purchased on their books to maturity, the labor market is getting better but there are still some areas of concern such as long-term unemployment and underutilized workers and the participation rate, the housing market has flattened but she expects it will pick up again, it would be better if Congress was part of the solution rather than part of the problem, the economy paused in the first quarter but we’re on the mend.

That’s a couple of hours of testimony and Q&A in a nutshell. I just saved you a lot of time. You’re welcome.

There is a lot of talk about a stock market bubble, almost everywhere you hear someone with an opinion, but of course no one knows for sure. You could look at many indicators that seem bubbly: high margin debt, Shiller PE Index at the highest levels since 1929 and 2000, frothy M&A activity, IPO activity has been or was hot for a while, just like back in the dot.com days.

Just look at the recent bloodbath for Twitter, following the six-month lockup combined with a bad earnings report; high flying tech stocks plummet back to earth in 140 characters or less. If you want frothy, look at Tesla, which reported a $50 million dollar loss after the close of trade today; and even though revenue increased, share prices took a hit. It’s that kind of action that makes it feel like a bubble, but that doesn’t mean it is a bubble; not today anyway.

Venture capital certainly was one of the culprits driving up stock market prices in 1999 and 2000. Then, as now, low interest rates also played a part. In fact, the bursting of the bubble was related to the Federal Reserve raising interest rates six times between 1999 and 2000.

Maybe the Fed learned a lesson. While an overvalued stock market seems related to the Federal Reserve’s monetary policy and a chart of the S&P 500 is almost a mirror image of the Fed’s balance sheet, one of the goals of "Quantitative Easing," the Fed's program of buying treasuries to increase monetary supply and reduce the value of bonds, was to bolster other assets relative to bonds. With interest rates still so low, bonds are a lousy alternative to generate return, leaving more money in the stock market than if we were to have higher interest rates.

Fed Chair Yellen seems to be cautious with statements about interest rates and well aware that raising rates could reawaken the sleeping bear. Plus, we still have about $15 trillion in debt constantly rolling over, and if interest rates tick higher, that debt turns ugly fast. The stock markets know this and keep prices high. Of course, even with this knowledge, the business cycle hasn’t been repealed and the exit from QE and a Zero Interest Rate Policy remains fraught with peril.

Fed chairwoman Janet Yellen said, “many recent indicators suggest that a rebound in spending and production is already under way, putting the overall economy on track for solid growth in the current quarter.” The question is whether that pickup in output is being accomplished through better productivity or more hiring and longer workweeks. We got data on that issue this morning from a Labor Department report showing productivity fell at a 1.7% pace in the first quarter.

Some of the first-quarter drop reflects the drag on output caused by the harsh winter. But looking longer-term, productivity growth has slowed. Compared to a year ago, productivity is up a weak 1.4%. Of course, the demand for labor has not revved up much in recent quarters, so the growth in unit labor costs is also muted, up just 0.9% in the year ended in the first quarter. Part of the problem is that companies have been involved in relentless cost cutting, and after a while you can’t get any more water out of that well.

Of course, we haven’t recovered fully from the financial crisis. Ordinary Americans took huge balance sheet hits in the crisis: the loss of home equity, which only in some markets has come all the way back; job losses and pay and hours reductions, which led many to run down savings as they readjusted; declines in stock market portfolios; the flip side of ZIRP, the Zero Interest Rate Policy, is lower income thanks for retirees and other income-oriented investors.

Before the crisis, if someone was hit with a financial emergency, like an accident or sudden job loss, those who had houses could often draw on home equity. Yesterday we reported that negative equity is falling; bit by bit over the years, homeowners have been climbing out of that hole, and new data from Black Knight Financial Services show that borrowers are approaching a threshold that will see only one in 10 US borrowers underwater on home loans.

Of course, the main reasons why negative equity has dipped is a combination of slightly higher prices, but also because foreclosures wiped away the mortgages of many of the most indebted. In January 2010, 10% of borrowers owed at least 50% more than their homes were worth. By January 2014, that number fell to 2% of borrowers.

With that home equity piggybank depleted or non-existent, the last-ditch financial fallback is accessing retirement savings; not complete liquidation, but just dipping in with an early withdrawal or a loan. Borrowing is limited to a maximum of half of plan assets or $50,000, whichever is lower. While the borrowing is interest free, the funds need to be repaid in five years. Early withdrawals typically carry a 10% penalty.

A Bloomberg story details how prevalent 401(k) withdrawals have become. For the latest year in which data is available, 2011, 4% of all households paid early withdrawal penalties. A Federal Reserve study found that 9.3% of taxpayers with retirement accounts paid early withdrawal penalties, an increase from 7.9% in 2004. Adjusted for inflation, the government collects 37% more money from early-withdrawal penalties than it did in 2003. Meanwhile, the amount of home equity loans outstanding was $704 billion in 2013, down 38% from the 2007 peak.

In addition to the lack of recovery from the financial crisis, we still haven’t fixed the underlying problems. Bank of America is holding its annual shareholder meeting. Not surprisingly, the hot topic dealt with some missing money; $4 billion, more or less; an accounting error that resulted in not enough capital to pass the Federal Reserve stress test, consequently dashing the buyback program and halting any dividend increases and sending share prices down 5% so far this year.  

The error, unearthed by a bank employee earlier this month, stemmed from how Bank of America calculated certain losses on bonds that it acquired when it bought Merrill Lynch in the depth of the financial crisis. The bank had been making the same mistake for several years. As a result of the error, Bank of America has $4 billion less capital than it had represented to the Federal Reserve on this year’s stress test.  The bank still faces billions of dollars of legal costs to settle cases with federal prosecutors over its mortgage lending practices. Executives have declined to detail how much they are reserving for those cases because it could hurt their negotiating position. Not surprisingly, many shareholders are opposed to increasing executive compensation packages this year.

Charles Holiday, the Chairman of BofA said: “I believe very strongly that this bank is not too big to manage.’’

James Gorman is CEO of Morgan Stanley; speaking at a conference in New York, Gorman said he didn’t believe more bankers should have gone to jail for the financial crisis. At first blush, Gorman makes a good argument, but there are some holes. Gorman said, “Bad judgment, incompetence, negligence, greed: these might be socially unacceptable… but they’re not criminal offenses.” And that’s true, and I don’t believe any Wall Street bankers  have been criminally charged with bad judgment or for being greedy; in fact, no major Wall Street banking executive has been criminally charged… with anything. However, fraud, conspiracy to commit fraud, aiding and abetting fraud, forgery (as in robo-signing), perjury (as in false documentation), intentional misrepresentation or lying publicly about securities (as in securities fraud), violation of Sarbanes-Oxley, and a few other things that took place – those are indeed criminal offenses.

Gorman also said Glass-Steagall should not have been repealed, even though he doesn’t think it played a role in the financial crisis. Again, not exactly correct. Glass-Steagall  was the depression-era law that kept securities underwriting and trading separate from commercial banking; in other words, investment banks could be involved in speculative trading, they just couldn’t use depositors money for their gambling. Glass-Steagall was repealed in 1999 in a sneaky bit of legislative legerdemain that was written by and allowed the merger of Travelers and Citicorp to create Citigroup. Since then, the US government has been forced to rescue Citigroup 3 times. The repeal of Glass-Steagall might not have caused the financial crisis but it certainly played a role.

Gorman now joins some interesting company calling for the reinstatement of Glass-Steagall. Former CEO’s of Citigroup John Reed and Sandy Weill now regret the repeal and recognize the dangers. Politicians from both sides of the aisle have introduced legislation over the past few years to reinstate Glass-Steagll and effectively break up the big banks to protect taxpayers and restore confidence in the financial system.