Thursday, February 20, 2014 - Searching for Inflation

Searching for Inflation
by Sinclair Noe

DOW + 92 = 16,133
SPX + 11 = 1839
NAS + 29 = 4267
10 YR YLD + .02 = 2.75%
OIL + .02 = 102.86
GOLD + 12.10 = 1324.00
SILV + .29 = 21.92

The Conference Board’s Leading Economic Indicators rose 0.3% in January following no change in December. Over the six months through January, the LEI rose 3.1%. The LEI tracks 10 indicators designed to signal business cycle peaks and troughs. In the most recent report, 5 of the 10 indicators were positive, including a drop in jobless claims and a pickup in factory orders; on the negative side, declines in building permits and hours worked. Meanwhile, the Conference Board’s index of coincident indicators, a gauge of current economic activity, rose 0.1 percent for a second month. Overall, the leading indicators point to moderate expansion once the nation gets past inclement weather, with the caveat that consumer demand needs to pick up. No surprises in that report.

The Consumer Price Index rose 0.1% in January after a 0.2% gain in December. The CPI measures prices at the retail level. The core rate, excluding food and energy prices, also rose 0.1%. Over the past 12 months, consumer prices were up 1.5%, and the core CPI was up 1.6%. Energy costs increased 0.6% from a month earlier and were up 2.1% over the past 12 months. Food costs rose 0.1%. Gains in the cost of hotel rooms, medical care and rents were mostly offset by declining costs for new and used cars, clothing and airline fares.

Yesterday, Fed policymakers released the minutes of the January FOMC meeting and we learned they had expressed concern about inflation being too low. Some participants wanted an “explicit indication” in their annual statement on policy goals that prices persistently above or below their 2 percent inflation target would be “equally undesirable.”

Prices are about to move higher, at least for food. It’s pretty simple; the state that produces the most vegetables is going through the worst drought it has ever experienced. Just consider the statistics regarding what percentage of the produce you eat is grown in California: 99% of artichokes, 44% of asparagus, 66% of carrots, 50% of bell peppers, 89% of cauliflower, 94% of broccoli, 95% of celery, 90% of lettuce, 83% of spinach, 33% of tomatoes, 86% of lemons, 90% of avocados, 84% of peaches, 88% of strawberries, and 97% of plums.

If fruits and veggies don’t fill your plate, you’ll want to take note that the US cattle herd is now the smallest it has been in 63 years. The drought in California and also Texas means that there are fewer cows, as ranchers in the West sell off their livestock because grazing land has dried out and buying feed is prohibitively expensive. And you can’t just snap your fingers and have a cow ready for market; it takes a couple of years. The lower supply means higher prices; offsetting the supply is lower demand; nearly 40% of Americans say they eat less beef today than 3 years ago.  Ground beef prices were up 5% for the past year. Chicken prices up more than 18% in the past 3 years, and bacon up 23% in the past 3 years.

If there is any good news on the food front, the US Department of Agriculture today reported that corn, soybeans, and wheat prices should be lower over the next 12 months.

Anyway, no inflation on the horizon in today’s CPI report. And the reason is not just what is happening in the USA. Goods inflation is exposed to global trade. When China was flooding the world with low cost goods in the 1990s and 2000s, it put immense downward pressure on consumer goods prices and held down the overall U.S. inflation rate. Unlike the 1990s and early 2000s, the latest downdraft in goods inflation is likely being driven not so much by an influx of cheap goods produced by low-cost emerging market labor, but by a slowdown overseas driven by over investment in emerging markets during their boom. An acceleration of global growth is probably a necessary condition for headline inflation to accelerate.

That’s just a small part of the inflation picture. The service sector makes up a larger part of the US economy these days. Services inflation is highly exposed to domestic housing and the cost of domestic labor. In other words, rent and wages. The owners’ equivalent rent index had been rising at a steady pace through most of 2012 and 2013, with 12-month percent changes hovering around 2%, but toward the end of 2013, the pace picked up. By January OER was up 2.5% compared to year-ago levels. That’s not a hot pace for housing costs but it bears attention. Meanwhile, wages have been flat for what seems like forever, and that means there is no demand to push prices higher, at least for services. For that matter, we may be setting up a divergence between wages and rents. You can’t push rents higher unless people earn enough wages to pay the rent.

The Federal Reserve Bank of New York has issued a paper on why people are having a hard time finding a job. The old excuse was “structural unemployment.” The new excuse is a decline in “job matching efficiency.”

The White House budget to be released early next month will propose $56 billion in new spending on domestic and defense priorities and drop a proposal that was included in last year's budget as a way to attract Republican support; a plan that would have cut Social Security benefits based on a “chained CPI”. The budget would aim to reduce the emphasis on austerity that has been the preoccupation of American politics for the past four years.

A White House official said President Obama decided to release a budget that fully represents his "vision," rather than to continue to pursue a fiscal agreement, because Republicans have refused to engage in good-faith negotiations over the nation's top priorities.

The new budget is due March 4.

The protests in the Ukraine have escalated into gun battles between police and anti-government forces. The death toll has climbed to 75. Three hours of fierce fighting in Kiev's Independence Square, which was recaptured by the protesters, left the bodies of over 20 civilians strewn on the ground. Nearby, President Viktor Yanukovich was meeting with a EU delegation trying to broker a political settlement. For now, there is no agreement.

Increasingly, we’ve seen big banks involved in commodity markets, and an interesting idea was recently tossed out by Theodore Butler regarding the origins of the 2008 crash. I don’t know if it is true but it’s an interesting story.

You’ll remember that Bear Stearns imploded six years ago; JPMorgan took it over as the doors were closed. It was an unprecedented fall. As Butler said: “The cause was said to be a run on the bank as nervous investors pulled assets from the firm. Bear Stearns was said to be levered by 35 times, meaning it had equity of $11 billion and total assets of $395 billion. This is a very small cushion if something negative suddenly appears… Since Bear had a significant presence in sub-prime mortgages and that market was in distress, it is assumed the fall of the firm was mortgage related. That may be true, but there was no general stress in the stock market through mid-March 2008 reflecting a credit crisis. Was there instead some specific trigger behind the company’s sudden collapse?”

One idea is that Bear Stearns was short the silver market. The exact holdings haven’t been established but the 4 largest short traders in silver was at an extreme level of more than 300 million ounces; triple the long positions, and Bear Stearns was the largest short in COMEX gold and silver contracts.

The day of Bear Stearns demise coincides with historic high points in gold and silver. “Gold prices rose from under $800 in mid-December 2007 to $1,000 in mid-March 2008, a gain of more than $200. Silver prices rose from under $14 in mid-December to $21 when Bear Stearns failed on March 17, 2008. That was a gain of $7. This was the highest price for silver and close to the highest price of gold since 1980. Obviously, a $200 rise in the price of gold and a $7 rise in the price of silver is not good if you are the biggest gold and silver short…. Bear Stearns had to come up with $2.7 billion because gold and silver prices rose sharply in the first quarter of 2008 and the company bet the wrong way. That it couldn’t come up with all the margin money for the losses in gold and silver, is the most visible reason it went under.”

We can’t say with certainty that this is what happened to Bear Stearns, but it is probably more than mere coincidence that JPMorgan ended up acquiring Bear, and really, it makes  sense, and at the very least it’s a great story.

Tuesday, November 12, 2013 - Supremely Happy

Supremely Happy

by Sinclair Noe

DOW – 32 = 15750
SPX – 4 = 1767
NAS + 0.13 = 3919
10 YR YLD + .02 = 2.77%

OIL – 2.10 = 93.04
GOLD – 15.70 = 1267.20
SILV - .65 = 20.80

We've been hearing from Federal Reserve big wigs about their ideas for taper. Today, Federal Reserve Bank of Atlanta President Dennis Lockhart said he wants to see inflation accelerate toward the Fed’s 2% goal before the central bank reduces $85 billion in monthly bond purchases. Lockhart also wants to see economic growth pick up to around 3%.

In a speech, Lockhart said: “To achieve a faster pace of growth, it’s my opinion that we’ll need to see” greater consumer spending and a decline in “fiscal drag.” Even though those targets for inflation and growth are a long way off, Lockhart says the taper, reducing bond purchases, “ought to be on the table at upcoming meetings” by the FOMC, including the December 17-18 meeting.

There has been a common thread in mainstream economic forecasting lately. It goes like this: "Yes, 2013 has been rough. But growth should pick up in 2014." The latest example is from the OECD, the organization of leading developed nations projecting that improvement just around the corner, as its index of leading indicators rose.

The same story shows up in almost any mainstream forecasters' estimates. For example, in their last official forecasts, top Federal Reserve economists concluded that 2013 US economic growth was on track to be only 2 to 2.3 percent. But they forecast that would rise to the 3 percent ballpark in 2014 and as high as 3.5 percent in 2015.

The consistent pattern for the last four years has been to project improving growth in the year ahead, and then to mark down those projections when the rosier future does not arrive. 

Perhaps the US economy is gathering traction, or perhaps last week's rate cuts by the European Central Bank signal a global competition to cut the value of currencies; the result is that the dollar is bouncing off its lowest levels since February. Weak inflation readings offer the Fed a rationale to continue securities purchases; it also locks the Fed into securities purchases. Right now the PCE reading of inflation is just below one percent and there really isn't any indicator of a big increase in inflation; and if the Fed starts tapering now, they run the risk of increasing deflationary pressures.

When the Department of Justice blocked the American Airlines, US Airways merger, we told you it was probably a negotiating tactic. It was. DOJ has reached an agreement that will have the merged airline give up flight slots and gates at seven different airports, the big changes coming at Washington Reagan and New York La Guardia. So, now that a deal has been reached, the two airlines are expected to complete their merger in December, just in time for the holiday travel season.

In a settlement expected to be announced this week, Bloomberg reports Johnson & Johnson will pay more than $4 billion to resolve thousands of lawsuits over its recalled hip implants in the largest settlement of US legal claims over a medical device. The accord will resolve more than 7,500 suits filed in federal and state courts by patients who’ve already had defective hips removed. The company will likely pay an average of $300,000 for each of those removals. The agreement doesn’t bar patients whose hips fail in the future from seeking compensation from J&J; that means the settlement is uncapped in terms of its total value.

Timothy Massad is expected to be picked to head the Commodity Futures Trading Commission, replacing the retiring Gary Gensler. The CFTC is the regulator of the derivatives markets, estimated at more than $600 trillion on Wall Street; perhaps double that amount worldwide. It might be a misnomer to say the CFTC regulates the derivatives markets, because those markets are largely unregulated. The CFTC, long an unexciting agency overseeing agriculture futures, has only just been put in charge of the swaps markets, and has yet to write some of its planned rules. Massad worked as the head of the Troubled Asset Relief Program until 2011.

Six years after the collapse of a couple of Bear Stearns hedge funds and the fight continues over the cause of Bears' demise. Liquidators seeking to recover money for investors have filed a fraud lawsuit against three major credit rating agencies: Standard & Poors, Fitch, and Moody's. The suit accuses the credit rating agencies of assigning artificially high credit ratings to the mortgage bonds in the funds. When those bonds collapsed, the funds failed, resulting in more than $1 billion in investor losses.

The credit rating agencies made the mistake of allowing employees to communicate by email about the work they were sort of doing. “It could be structured by cows and we would rate it,” an S&P employee said to a co-worker in a text message from 2007. A Moody's employee wrote: “We sold our soul to the devil for revenue.” In an email, another S&P employee called the firm’s ratings practices a “scam.”

The lawsuit is not the first that seeks to hold the ratings agencies accountable for losses incurred during the financial crisis. The Justice Department filed a civil fraud action this year against S&P, the first federal enforcement action against a credit rating firm.  It is also not the first legal action related to the two Bear funds, which collapsed in July 2007. Federal prosecutors brought criminal securities fraud charges against the funds’ managers, Ralph Cioffi and Matthew Tannin. The two fought the charges and a jury found them not guilty after a trial.

A report by the Financial Crisis Inquiry Commission found the  credit ratings firms were “key enablers of the financial meltdown.”

Mortgage bond investors have had mixed results bringing civil lawsuits against the ratings agencies. S&P and the other agencies have argued that their ratings are speech that is protected by the First Amendment. A number of judges have agreed with the ratings agencies and tossed out these lawsuits. Others have said the ratings were not opinions, but misrepresentations that were possibly the result of negligence or fraud.

S&P also said its ratings were not to be relied on, in part because the investors had the same information as it did.

In July, a federal judge denied S&P’s motion to dismiss the government’s case and called its defense “deeply and unavoidably troubling.” The judge, David Carter of Federal District Court in Los Angeles, asked, “If no investor believed in S&P’s objectivity, and every bank had access to the same information and models as S&P, is S&P asserting, as a matter of law, the company’s credit ratings service added absolutely zero material value as a predictor of creditworthiness?”

This week, the operator of Japan's crippled Fukushima nuclear plant will begin removing 400 tons of highly irradiated spent fuel in a hugely delicate and unprecedented operation fraught with risk. Carefully plucking more than 1,500 brittle and potentially damaged fuel assemblies from the plant's unstable Reactor No. 4 is expected to take about a year. If the rods - there are 50-70 in each of the assemblies, which weigh around 660 pounds and are 15 feet long - are exposed to air or if they break, huge amounts of radioactive gases could be released into the atmosphere.

When the time comes, extracting spent fuel from the plant's other reactors, where radiation levels are much higher because of core meltdowns, will be even more challenging. Reactors No. 1 and No. 3 sustained heavier damage than No. 4 as a result of the March 2011 earthquake and tsunami, but Reactor No.4 is perched nearly 60 feet high in a building that has buckled and tilted and could collapse if another quake strikes. Also, if the pool housing the fuel assemblies is punctured and the water drains away, there could be a fire that releases more radiation than during the 2011 disaster

You've heard that some retailers are trying to kill Thanksgiving; they're moving Black Friday to Thursday, Thanksgiving Day; some are even starting sales at 6AM on Thanksgiving Day, so as to totally ruin any sense of the holiday. The big chain stores include: Old Navy, Kmart, WalMart, Target, Staples, Sears, Best Buy, Toys Rus, and others. We've been told that the reason behind the move is because of a calendar anomaly this year that resulted in 6 fewer shopping days between Thanksgiving and Christmas. The real reason is far more insidious and diabolical.

It is in fact, a socialist plot, and it started in Venezuela. About six months ago, Hugo Chavez, the Venezuelan president and dictator died; his replacement is a man named Nicolas Maduro, and Maduro has declared that Christmas should be celebrated earlier; he moved it to the first Saturday in November. So, I'm a little late with the story. And then he ordered government employees to be paid their Christmas bonuses in November, as he turned on the Nativity lights on the Presidential Palace. But why did the Venezuelan president decide to defy the calendar in such a bizarre manner? Well, Maduro announced that he simply wanted to bring “happiness for everyone.” And it's all part of a bigger plot.

Last week, Maduro sought to raise the level of happiness throughout the country by introducing the Deputy Ministry of Supreme Social Happiness. Maduro defended this cabinet-level creation, by remarking, “It’s provocative to make it a ministry, right?”

He then went on to add, “That’s the main message I wanted to give here. Let’s be happy and make others happy too.”

Monday, October 21, 2013 - JPMorgan's Deal

JPMorgan's Deal

by Sinclair Noe

DOW – 7 = 15, 392
SPX + 0.16 = 1744
NAS + 5 = 3920
10 YR YLD + .02 = 2.61%
OIL – 1.63 = 99.48
GOLD - .80 = 1317.60
SILV + .28 = 22.34

Apparently, over the weekend, JPMorgan Chase reached a $13 billion settlement with the Department of Justice and the New York Attorney General over the sale of mortgage backed securities back in the days of the housing bubble. We're still waiting for details, but it looks like the tentative deal would resolve charges that JPMorgan misrepresented the quality of loans that had been packaged as mortgage backed securities, including mortgage backed securities packaged by Bear Stearns and Washington Mutual, the two failed institutions acquired by JPMorgan in 2008.

And one of the unique features of this settlement is that it does not end a criminal investigation of the bank. Prosecutors did not want to end the criminal probe before they were sure of its findings. The investigation could take another several months. Ending the criminal probe was a long shot and the bank was not interested in holding up all the other settlements to wait for that. Civil cases require a lower burden of proof than criminal cases, and can often be wrapped up quicker than parallel criminal proceedings. In other words, they knew they could lose; so they took a deal.

Now, $13 billion sounds like a lot of money, and it is for you or me, but not so much for JPMorgan. Still, the bank's legal problems are not going away. JPMorgan has set aside a total of $23 billion to pay for legal issues, and faces more than a dozen probes globally.

The fine of $13 billion is roughly half of what JPMorgan pulled down in 2012 and only about 1.5x what the bank paid its executives through the first nine months of this year. Shares are up over 70% since 2008, trouncing the returns of its banking peers. JPMorgan shares are flat on the day and actually up more than 3% since the company reported its first quarterly lost under Dimon last week after taking a huge hit on legal fees and fines.

The settlement is composed of $4 billion to settle claims that it lied to Fannie Mae and Freddie Mac about the quality of mortgage securities is sold them, $4 billion in consumer relief (which never seems to provide much relief) and $5 billion in penalties. The $4 billion in consumer relief spread among "Americans" more than five years after the fact is less than it may seem. And don't forget that the bank will likely write-off the fines, taking a tax break on any payment and relief.

The Justice Department and JPMorgan are reportedly still haggling over the degree to which the bank has to admit to misbehavior or failure to follow its compliance policies. Additionally, Holder and other enforcement agencies may use the JPMorgan case as precedent to expand their investigation into Wall Street malfeasance, among other things extending the statute of limitations from five to ten years.

Beyond mortgage-related probes, federal prosecutors are looking into whether JPMorgan broke laws in its handling of derivatives bets known as the "London Whale trades" that cost the bank more than $6 billion in trading losses, and more than $1 billion in regulatory fines so far. Also, regulators are examining whether the bank gave jobs to children of executives at Chinese-owned companies to secure business in China. And don't forget the Libor rate rigging scandal; plus, about a dozen more investigations globally. A billion here a billion there and pretty soon you're talking about real money; a legal fund of $23 billion might not be enough.

JPMorgan CEO Dimon has argued to the Justice Department that much of the conduct at issue stems from two firms the bank acquired with the encouragement of the US government during the height of the crisis, Bear Stearns and Washington Mutual. It is unfair to penalize the bank for alleged sins that took place before it owned the two banks, Dimon has complained. He has also said that the investigation will make JPMorgan reluctant to buy troubled institutions again. But Dimon's whining doesn't match recent statements.

In the last couple of annual reports from JPMorgan, Dimon brags that the bank absorbed Bear Stearns and Washington Mutual without hurting its capital levels. That is at least partly because JPMorgan bought both banks at fire-sale prices. The bank bought Washington Mutual essentially for free, paying $1.9 billion for a bank that had $40 billion in shareholders' equity just before the deal, and then turned around and booked an immediate $2 billion profit.

At the time of the deals, JPMorgan estimated that Bear Stearns and Washington Mutual combined would add about $3.5 billion to net income annually. If correct, that would add up to about $16 billion in extra profit since 2008, trumping the $13 billion in fines. But the truth is that JPMorgan has likely pocketed much more than that. Remember the Fed took almost all of the toxic assets, and they left the good stuff. The result is that JPMorgan booked an extra $6 billion in net interest income in 2008 alone.

The government has said it is taking the nature of the WaMu and Bear Stearns acquisitions into account. It is unclear how the fines the bank is expected to pay reflect that. Some legal experts not involved with the talks say that JPMorgan does not have much of an argument when it comes to avoiding civil liability for Bear's and WaMu's mortgage abuses.

The line of argument misses another important point. And it typifies the heads-I-win, tails-you-lose mentality that gets so many Americans angry at Wall Street. When you buy a company, or a piece of property, you don’t just acquire the assets. You acquire the liabilities—the contracts, the leases, the bank debt, the environmental problems. The price you pay isn’t just for the good stuff. You conduct due diligence, and you adjust the price accordingly. JPMorgan execs claimed they were well aware of problems at Bear Stearns, and they were eager buyers; the original offering price on Bear Stearns was $2 per share, but when rival banks showed interest, JPMorgan upped their offer to $10 per share; they also negotiated to have the Federal Reserve cover possible losses from about $30 billion in risky Bear Stearns assets.

And only about 70% of the garbage mortgage backed securities behind the current settlement can be placed at the feet of Bear Stearns and WaMu; 30% of the securities in question came directly from JPMorgan. The fact is that all these bankers were packaging the worst of the mortgages into MBS and selling them to government-sponsored entities such as Fannie Mae and Freddie Mac, as well as large institutional buyers like pension funds; and the banks were claiming the mortgage-backed securities were good, when they knew they were not. That was standard operating procedure for the banks.

The banksters broke the law and they got away with it, and it's been going on for a long time, and even with this weekend announcement of a tentative settlement, they continue to get away with it. The banksters have been considered too big to jail. Lanny Breuer of the DOJ refused to prosecute banksters, probably because he knew he would soon be going back to representing them in the private sector. Attorney General Eric Holder has expressed concerns about the economic consequences of criminal prosecution of big banks or big bank execs. And even with the news that they are keeping the criminal investigations open while reaching a civil settlement, it doesn't mean there will be criminal charges.

How is it possible to have billions of dollars in civil settlements and nobody broke the law along the way? It isn't. And we will never get rid of the illegality in banking until we see someone or several facing criminal charges. Having gotten away for many years with relatively tiny, slap-on-the-wrist fines that were in most cases less than the profits made on the crimes they committed, and fines where they were not required to admit wrong-doing but still got exemption from any future legal action, and fines that they can write-off and deduct from corporate taxes; well, a big $13 billion fine with no criminal side settlement is a different ballgame entirely. If you want to change reckless behavior, the kind of behavior that cost the country more than $15 trillion, and nearly destroyed the global financial system then maybe the punishment should be tougher than the justice meted out to some kid with a joint in his backpack.

So, why the change in attitude toward getting tough with the banksters? And why would Jamie Dimon accept a fairly large civil penalty, without clearing the deck of potential criminal charges? If these were really legacy issues only related to Bear Stearns and WaMu, it is unlikely Dimon would accept a deal quite so easily. You have to consider the possibility that there are still skeletons in the closet, there are still violations, criminal violations that could not only bring down the banks but also multiple bank executives. For a long time, the bankers played hard ball. Now, Jamie Dimon seems to be doing little more than whining. And you also have to consider that if the banksters were involved in illegal activities in 2008, they didn't get religion and clean up their wicked ways. The bad practices have continued and continue to this day.

Right now, the government has leverage, and likely not just against JPMorgan. There’s going to be more of this to come and maybe the JPMorgan settlement will be the template for other banks that were big players in the mortgage-backed securities market, including Citigroup, Deutsche Bank and Royal Bank of Scotland.

Indeed, The Financial Times reports Monday that Bank of America is in talks to pay a $6 billion settlement to the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac; that’s even larger than the $4 billion JPMorgan is earmarked to pay the FHFA, according to numerous reports. 

Thursday, July 18, 2013 - Those FERCing Energy Traders

Those FERCing Energy Traders

by Sinclair Noe

DOW + 78 = 15,548
SPX + 8 = 1689
NAS + 1 = 3611
10 YR YLD + .04 = 2.53%
OIL + 1.74 = 108.22
GOLD + 8.40 = 1284.00
SILV + .09 = 19.48

Record high closes for the the Dow & the S&P, along with record intra-day highs.

I know you're all wondering why we called this meeting; well, I'd like to report that the company is doing all right, we're managing to scrape by; but we'd be doing a lot better if the staff in the home office would get off their lazy butts and get some work done for a change.

Sounds a bit harsh, doesn't it?

Yet that is how Ben Bernanke started his testimony before the House of Representatives yesterday. Actually, what he said was: "The economic recovery has continued at a moderate pace in recent quarters despite the strong headwinds created by federal fiscal policy."

Bernanke has a point. Whatever motivation you assign to monetary policy, there are limits to the potential benefits, and those benefits are primarily limited to banks. Accommodative monetary policy is slow to flow to Main Street.

Wall Street has been very happy with QE, as we discussed yesterday. The bankers and hedge funds, and the shadow banks feel the future is assured as long as the economy remains weak and the Fed continues cash infusions into the banking system, and therefore most investments will succeed. In that kind of environment, the income earning ability of an asset is secondary to the capital gains potential. The Wall Street crowd pays higher and higher prices for assets and they finance their purchases with ever rising mountains of debt building up on the Fed's balance sheet. If you want to see the direction of the stock market, just look at a chart of the Fed's balance sheet.

Sure enough, Bernanke says he'll continue with easy money and the market hits another record today; just like clockwork. And that's all fine until some trader somewhere makes a bad mistake, and then everything freezes, and liquidity turns to block hard ice. Bernanke, as a student of the Great Depression, probably doesn't want to see that happen. And so on his Farewell Tour of Congress, Bernanke has pushed for fiscal policy to bridge the disconnect between the markets and Main Street.

Today Bernanke appeared before the Senate Finance Committee and the prepared remarks were the same as yesterday's and I haven't seen much of anything in the question and answer session to raise a flag: the future of monetary stimulus will be tied to the health of the economy, nothing is changing, and by the time it does change, Benny will be retired. Thank you and goodnight Mrs. Calabash, wherever you are.

Let's all jump in the Way Back Machine. You may remember that back in the 1990s, the US began deregulating electricity markets. States like California, New York, and Texas reorganized their “markets” to facilitate wholesale buying and selling, in other words, trading of electricity. You remember all that talk about free markets and such.

Now, let's set the Way Back Machine to the Summer of 2000; a typically warm California summer had people cranking up the AC, and Enron was cranking up the manipulation. Back in 2000, the Golden State had installed generating capacity of 45 gigawatts, and when everybody turned on the AC, the demand reached 28 gigawatts; energy traders took power plants offline for maintenance during peak demand. The result was rolling blackouts and power selling at a premium price, sometimes up to a factor of 20 times normal value.

Fast forward to March 2013; the Federal Energy Regulatory Commission, or FERC, alerted JPMorgan that it would recommend penalties against its power-trading unit. The notice said JPMorgan devised "manipulative schemes" that transformed "money-losing power plants into powerful profit centers." The alleged foul play stems from the bank's 2008 takeover of Bear Stearns, which was then at death's door due to its risky investments in the mortgage market. Turns out that Bear Stearns also had interests in out-of-date power plants, which JPMorgan acquired as part of the takeover.

Feeeling pressure to generate profits, the JPMorgan traders devised a scheme to take advantage of something called a “make whole” provision in energy markets. First, traders would offer a low bid to deliver a minimum amount of electricity from a plant the next day, ensuring that the plant would be turned on. And then the next day, traders would offer a much higher bid for the plant's electricity, virtually guaranteeing that no one would buy. The plant would thus operate well below capacity, and lose money.

But they didn't lose money because the make-whole provision requires plants to be repaid if their profits don't make up for the costs of getting the plant up and running. JPMorgan allegedly took advantage of that fact to squeeze money out of the states and make a profit. So they were trading solely to influence the price and not based upon normal supply and demand fundamentals.

On top of the allegations, investigators are accusing JPMorgan of systematically covering up documents that revealed the alleged trading strategy, including one that showed Blythe Masters, the global head of commodities for JPMorgan, demanding a "rewrite" of a document that questioned whether the bank was acting legally. FERC is also claiming that Masters gave "false and misleading statements" about trading practices under oath.

Well, now it appears that FERC and JPMorgan are on the verge of a $500 million settlement. Earlier this week FERC ordered Barclays to pay a $470 million penalty for suspected manipulation of energy markets in California and other Western states. Barclay's is fighting the charges.

You may be wondering what JPMorgan, or Bear Stearns, or Barclays were they doing in the energy business? JP Morgan is a major player in all facets of the energy markets, not only electricity, but also oil, oil storage, petroleum derivatives such as gasoline and heating oil, diesel and more. They don't produce electricity or oil or gas; they trade these commodities. The big banks are players of particular significance, with virtual limitless funding available to them as 'banks' at the Fed window. They then trade, or gamble, or manipulate energy prices in the field of oil and gas and electricity; and their trading has an important bearing on the formation of prices of these commodities. If their actions in the electricity markets are an example of how they play the game, then one could well surmise that it is not only utility customers that are paying manipulated prices for their energy needs.

So, you can see that JPMorgan might be keen to settle this FERC accusation and move on. For you and me, $500 million sounds like a lot of money, but it's not like it would come out of Jamie Dimon's wallet; it's a write-down and the accountants will deduct it from taxes; and it's less than 7% of the losses attributed to the London Whale; and you recall that was, according to Dimon, nothing more than a “tempest in a teapot.”

Which means that the overall deterrent value of the FERC settlement is zero, and it's just a matter of time until the next Enron, or Barclays, or JPMorgan manipulates the energy markets in a way that is deemed egregious and illegal. Meanwhile, they continue to legally trade in the energy markets casino.

Just look at the earnings results from the most recent reports: Goldman’s quarterly profits doubled, with debt underwriting up 40% to a record, and fixed income currency and commodities (trading) up 12%. Bank of America’s Q2 profit rose 63% based on “global markets” fixed income, currency, commodities, and equity trading up a reported 93%. Citicorp’s Q2 profits were up 42%, with profits up 63% from trading stuff. And JPMorgan’s profits in the quarter rose 31%, with a 38% rise in investment banking fees, a 19% rise to $2.8 billion from investment and corporate banking, a 50% rise in debt underwriting and an 83% increase in equity business line.

So you know, nobody really knows how things like investment banking “fees” are calculated, or debt underwriting, or whether or not they include “market-making,” otherwise known a “trading,” that happens on the other side of underwriting and investment banking deals. And in America, no banker goes to jail because we believe in free markets. So everything is good because they're trading, and they're making money. Where does that money come from? You know the answer.

Monday, December 17, 2012 - Unconnected Dots

Unconnected Dots

by Sinclair Noe

DOW + 100 = 13,235
SPX + 16 = 1430
NAS + 39 = 3010
10 YR YLD +.05 = 1.76%
OIL +.71 = 87.44
GOLD + 1.90 = 1699.10
SILV -.03 = 32.38

President Obama and House Speaker Boehner met at the White House today. Aides from both parties said they were optimistic that a deal could be reached in the coming days to avert the "fiscal cliff," as lawmakers set the stage for action before a year-end deadline.

A senior Republican aide said: "There's been too much progress at this point and neither guy wants to go over the cliff." Although both sides still had major differences, investors were cheered by signs of progress. Major market indices moved higher in the afternoon, and some of that was the feel good part of the news cycle; we certainly need some good news. Now, we sit back and see whether it was yet another rumor.

Boehner, the speaker of the Republican-controlled House of Representatives, has edged closer to Obama's demand to raise taxes on the wealthiest Americans. In return, Obama is considering a measure that would slow the rate of growth of Social Security retirement benefits by changing the way they are measured against inflation.

Boehner has put forward a tax increase for those earning over $1 million annually, while Obama wants that threshold set at $250,000. Republicans could probably stomach a tax hike on incomes above $500,000. Boehner could float the broad outlines of a deal with rank-and-file members on Tuesday. If there are no strong objections, he could try to finalize the deal on Wednesday, the Republican aide said.

Votes could be held in Congress next week. Both sides declined to say what Boehner and Obama discussed at the meeting, which was also attended by Treasury Secretary Timothy Geithner.

However, the White House said Boehner's latest proposal doesn't meet its standards. Republicans want substantial spending cuts in return for increased tax revenue, but any proposal to trim popular benefit programs like the Medicare health insurance plan for seniors will face fierce resistance. Obama could also face strong opposition from Democrats if he agrees to Boehner's proposal to slow the growth of Social Security benefits by changing the way the cost-of-living increases are measured against inflation, an approach that could save $200 billion over 10 years. Obama also wants to head off another confrontation over the government's debt limit, which will need to be raised in the coming months. Republicans insist that any increase in the government's $16.4 trillion borrowing authority must be paired with an equal reduction in spending. Apparently jobs were not a big talking point in the negotiations.

The National Credit Union Administration , the regulator of credit unions has sued JPMorgan Securities and Bear Stearns over $3.6 billion in mortgage securities the bank allegedly sold to credit unions that collapsed because of losses from the securities.

The lawsuit by the National Credit Union Administration is its second against JPMorgan involving losses to credit unions. In June 2011 the agency sued it over some $1.4 billion in securities in which JPMorgan was the underwriter and seller. That suit is still pending. The actions add to a growing list of cases JPMorgan fighting over conduct by Bear Stearns, which JPMorgan acquired in 2008. The New York Attorney General sued JPMorgan in October alleging that Bear Stearns deceived investors buying mortgage-backed securities in 2006 and 2007.

In today's lawsuit, the NCUA alleged that Bear Stearns made misrepresentations in connection with the underwriting and subsequent sale of mortgage-backed securities to U.S. Central, Western Corporate, Southwest Corporate and Members United Corporate federal credit unions. The lawsuit, filed in federal court in Kansas, is the largest such lawsuit the regulator has filed to date. A JPMorgan spokeswoman declined to comment.

In the past two years the agency has brought similar actions against Barclays Capital, Credit Suisse, Goldman Sachs, RBS Securities, UBS Securities, Wachovia and others. Most of the cases are pending, but it has settled claims against Citigroup, Deutsche Bank Securities and HSBC for around $170 million.

The credit union regulator has been trying to recover losses related to the failure of five institutions that it seized in 2009 and 2010 after they ran into trouble due to the crumbling housing market. The wholesale credit unions have experienced more troubles than their retail counterparts because they did not face the same restrictions on permitted investments, leading to big losses during the financial crisis.

UBS will pay around $1.5 billion to settle charges that a group of traders at its Japanese unit rigged Libor interest rates. The fine, to be imposed by the United States and Britain, would be the latest blow to UBS after a $2.3-billion rogue trading loss in London last year, a $780-million fine after a U.S. tax investigation in 2009 and its near collapse in 2008 under the weight of losses on U.S. sub-prime mortgage lending.

UBS will admit that roughly 36 of its traders around the globe manipulated yen Libor between 2005 and 2010. The settlement talks are reportedly now centering on a fine in the region of $1.5 billion - somewhat higher than geusstimated last week and three times the $450 million levied on British bank Barclays Plc in June for similar manipulation of benchmark interest rates.

The fine against UBS would be the second-largest ever levied against a bank for wrongdoing, after Britain's HSBC last week agreed to pay $1.92 billion to settle a probe in the United States into laundering money for drug cartels.

UBS earned $4.6 billion in net profit last year and the bank has spent much of this year and last bolstering its capital. Paying $1.5 billion to settle the Libor probe would shave 50 basis points off UBS's capital ratios, but even after the fine, UBS would still be better capitalized than other banks.

UBS is expected admit to criminal wrongdoing by its Japanese arm, where one of its traders manipulated yen Libor and euro yen contracts. Admitting to criminal wrongdoing can be fatal for a bank, as it can lose its license. But by admitting to wrongdoing only at its Japanese subsidiary, where UBS employs 1,000 staff, it effectively ring-fences the damage, sparing its bigger units.

Individuals are also being targeted, mainly lower-level traders, offered up as sacrificial lambs. The UBS investigation centers on former UBS trader Thomas Hayes, but also includes other UBS bankers. Hayes, who joined Citigroup after leaving UBS in 2009, is one of three British men arrested last week by London police but later released on bail.

More than a dozen banks have been caught in the international inquiry into Libor rates, with most of the focus being on how rates were set between 2005 and 2008.

Royal Bank of Scotland is also expected to shortly reach a settlement on Libor manipulation. The bank will receive a penalty of more than $564 million.

Morgan Stanley, the lead underwriter for Facebook's initial public offering, will pay a $5 million fine to Massachusetts for violating securities laws governing how investment research can be distributed.

Massachusetts' top securities regulator charged that a top Morgan Stanley banker had improperly coached Facebook on how to disclose sensitive financial information selectively, perpetuating an unlevel playing field between Wall Street and Main Street.

Morgan Stanley has faced criticism since Facebook went public in May for revealing revised earnings and revenue forecasts to select clients before the media company's $16 billion initial public offering. This is the first time a case stemming from Morgan Stanley's handling of the Facebook offering has been decided.

Facebook had privately told Wall Street research analysts about softer forecasts because of less robust mobile revenues. A top Morgan Stanley banker coached Facebook executives on how to get the message out.

A Morgan Stanley spokeswoman said the company is "pleased to have reached a settlement" and that it is "committed to robust compliance with both the letter and the spirit of all applicable regulations and laws." The company neither admitted nor denied any wrongdoing.

The investigation into the Facebook IPO is far from over and other banks were involved. Goldman Sachs and JP Morgan also acted as underwriters. The underwriting fee for all underwriters was reported to be $176 million.

The state said a Morgan Stanley banker helped a Facebook executive release new information and then guided the executive on how to speak with Wall Street analysts about it. The banker rehearsed with Facebook's Treasurer and wrote the bulk of the script Facebook's Treasurer used when calling the research analysts. A number of Wall Street analysts cut their growth estimates for Facebook in the days before the IPO after the company filed an amended prospectus. Facebook's treasurer then quickly called a number for Wall Street analysts providing even more information.

The banker "was not allowed to call research analysts himself, so he did everything he could to ensure research analysts received new revenue numbers which they then provided to institutional investors." The consent order also says that the banker spoke with company lawyers and then to Facebook's chief financial officer about how to prove an update "without creating the appearance of not providing the underlying trend information to all investors."

The banker and all others involved with the matter at Morgan Stanley are still employed by the company.

Retail investors were not given any similar information, just in case you ever wondered whether the market is rigged against you.

In light of the HSBC money laundering settlement last week it is worth reading a report I found in the Guardian entitled Arizona funnels business to CCA through its school-to-prison pipeline

Thursday, November 8, 2012 - Tools in the Toolbox

Tools in the Toolbox

by Sinclair Noe

DOW – 121 = 12,811
SPX – 17 = 1377
NAS – 41 = 2895
10 YR YLD un = 1.63%
OIL + .60 = 85.04
GOLD + 14.60 = 1732.90
SILV + .47 = 32.41

Yesterday I was a guest on Bill Tatro's radio show: All About Money, 2PM Pacific and Mountain, right here on MoneyRadio. Most of the time Bill's show is Bill, and it's great; he's always entertaining and informative and I don't agree with everything he says but I think he does a great job of saying it; so I'm always a bit honored when he has me on as a guest. It's a different situation for me, being the guest, but Bill is an excellent interviewer. One of the questions he asked was, paraphrasing: “What tools does the Federal Reserve still have in their toolbox?”

I gave the basic answer that they didn't seem to have many tools left. I thought it was time for fiscal stimulus to match the Fed's already extraordinary use of monetary stimulus. But, as I said, this was a really good question and so I did a little more research, and today I'm going to talk with you about the tools left in the toolbox.

First, whether you like the Fed or not, the Fed's actions have had an impact on the economy and the economy has shown signs of recovery; I'm not sure what else to call it when you have 32 months of employment growth, the Dow Industrials have doubled from the lows of March 2009; not a great recovery but a recovery. Still we face a perilous path. This week's elections resulted in the status quo, there is still a fiscal cliff dead ahead, 9 of the countries in the Euro-Union are in a depression and the rest are facing recession and that affects the US, China is struggling. The IMF warned of a worldwide slowdown and the US is not immune. The path of austerity has has not worked in Europe, which should be no surprise because it didn't work in the United States back in the 1930s.

Corporate profits in the US are softening, the housing market still has a long way to go before it can be called normal again, and the average citizen is still concerned about jobs, and debt, and so they continue to keep a tight grip on their wallets.

There are a number of downside risks to the economy. We could see a shock that pushes the economy into another downward spiral, and if it happens again, it would probably be more difficult to contain than 4 years ago.

So, what's left for the Federal Reserve? Well, today, the Bank of England announced it would stop its bond buying program, the British equivalent of Quantitative Easing, and instead focus on a credit boosting initiative they call Funding for Lending Scheme, or FLS, to increase growth. The Bank of England also announced they would leave their benchmark interest rate at a record low 0.5%, while the European Central Bank announced they would hold steady at 0.75%. The thinking is that additional QE would only provide marginal benefits for the real economy, while creating longer-term risks of bubbles. Sound familiar? Of course, they could restart QE at any time but for now, they are looking at different tools.

The Funding for Lending Scheme means the British central bank will reward commercial banks with favorable rates if they provide more generous credit to help businesses wanting to expand and to create jobs. The scheme will also penalize banks if they fail to meet those goals. In other words, they will target bank lending.

The Fed actually has many tools to achieve their dual mandate to maintain stable money and maximum employment, but here's the deal, most of the tools the Fed has traditionally used tend to favor finance over industry, it works in favor of capital over labor, or Wall Street over Main Street. This has been a complaint for a long time. The Fed pumps money to the Wall Street bankers and they go out and gamble and the money never gets into productive hands. So, if the politicians are unwilling to stop acting like idiots (it may not be acting), then how can the Fed target money to the sectors that can really use it.

Well, in addition to running a printing press, it turns out that Bernanke is a pretty big-time regulator of the banking industry. The Fed could flex its regulatory muscle to unfreeze the risk-averse bankers who are still unwilling to lend—the same bankers whose reckless risk-taking nearly brought down the entire system four years ago. The Fed could create special facilities for directed lending (just as it did for the imperiled banking system) that gets the banks to relax lending terms for credit-starved sectors like small business. If bankers refuse to play, it could offer the same deal to financial institutions that are not banks.

What else? The Fed is already the biggest buyer and holder of mortgage backed securities; which is another way of saying they have quasi-nationalized the mortgage industry; and since they hold almost all the paper, who's to say they can't reduce debt for millions of underwater home mortgages? They've already managed to smooth the path to refinancing for millions of underwater homeowners; why not push debt reducing loan mods as well?

The Fed could also provide financing for major infrastructure projects: they could modernize the electric grid; they could finance green energy; they could build high speed rail systems or urban light rail; they can finance major road and bridge construction; massive water works projects; they could even finance education. The Fed could influence the investment decisions of private capital by backstopping public-private bonds needed to finance the long-neglected overhaul of the nation’s common assets.

But wait, wait (I can hear some of you sputtering right now) wait! The Fed can't do that! That's the job of the Congress; that's why we elect politicians, to make those kinds of decisions. If Bernanke crosses that line, it would surely be illegal. And I'm sure, Bernanke would like congressional cooperation, and he wants to avoid confrontation if possible.

Maybe Bernanke has already found an ally in the White House who is also exasperated with the obstructionist policies of the Republican leaders in Congress. And maybe that ally just won re-election and if the Republicans try to throw their weight around, he might just flex his own muscles.

Make no mistake, the Fed can carry out direct interventions to help the economy recover, it is legal, and it has used this power before, plenty of times. During the Great Depression, the Federal Reserve was given open-ended legal authority to lend to practically anyone if its Board of Governors declared an economic emergency. This remains the law today. The central bank can lend to industrial corporations and small businesses, including partnerships, individuals, and other entities that are not commercial banks or even financial firms. The Fed made thousands of direct loans to private businesses during the New Deal, and the practice continued for twenty years. Only in more recent times has the reigning conservative doctrine insisted that this cannot be done. 

The original authorizing legislation for such lending was enacted in 1932 as Section 13.3 of the Federal Reserve Act, and the wording was left deliberately vague. An emergency was defined as “unusual and exigent circumstances.” Whatever did that mean? In practice, it meant whatever the Board of Governors decided it meant. Fed governors must now get approval from the treasury secretary, but they do not have to ask Congress for permission. 

Section 13.3 is often depicted as antique legislation left over from the New Deal, but the provision is very much alive and active. It was invoked during the crisis of 2008. When Bear Stearns collapsed in the spring of 2008, the Fed declared “unusual and exigent circumstances” to legitimize its rescue. Bear Stearns was a brokerage house, not a bank. And then Section 13.3 was again use to justify the $180 billion bailout of American International Group. AIG is not a bank but a giant insurance company, and it was obviously insolvent. Normally, a failed corporation would proceed to bankruptcy court, where its creditors would fight over what was left. In this case, the Fed stepped in to save AIG.

The AIG bailout was not very popular, and so Congress tightened up the old law. Now, the Fed can still lend to “individuals, partnerships and corporations” if they are “unable to secure adequate credit accommodations from other banking institutions.” But it can no longer create a special lending facility to protect a single insolvent company.

Fed money is not exactly “free,” but it has this great virtue for government: it doesn’t cost the taxpayers anything; there may be ramifications but it's different than tax revenue. Fed expenditures do not show up in the federal budget, nor do they add anything to the national debt. Think of what this means when it comes time to negotiate the fiscal cliff? In a sense, this freshly created money belongs to the people, it's our money, and can be used in unusual ways to advance the shared public interest. Lincoln did this when he printed “greenbacks” during the Civil War. Various Fed governors have done it when they were faced with “unusual and exigent circumstances.” And don't forget the bailout of Penn Central. And, of course, the Fed used this to lend extensively during the Great Depression. And don't forget that Bernanke is a student of the Great Depression.

Does the Fed have any tools left in the toolbox? You better believe it.