Thursday, September 6, 2012 - Free Money With Strings Attached

Free Money With Strings Attached

-by Sinclair Noe

DOW + 244 = 13,292
SPX + 28 = 1432
NAS + 66 = 3135
10 YR YLD +.08 = 1.67%
OIL - .67 = 95.82
GOLD + 7.90 = 1702.30
SILV +.44 = 32.81
PLAT + 10.00 = 1589.00

Pop Quiz.

Q: What does Wall Street love?

A: Free money.

The Standard & Poor’s 500-stock index jumped 2 percent by the close to its highest level since January 2008. The Dow Jones industrial average added about 244 points, or 1.9 percent. And the Nasdaq composite index gained 2.2 percent for its highest close since 2000. In Europe, stock market indexes closed with gains of more than 2 percent, with Spanish and Italian stocks up more than 4 percent. The DAX in Frankfurt added 2.9 percent. The FTSE 100 in London gained 2.1 percent.

Today, the European Central Bank announced they will launch a new and potentially unlimited bond buying program to lower borrowing costs for countries struggling with debt. The idea is to buy bonds with maturity of three years or less. ECB President Mario Draghi claims this is within the mandate of the ECB. Germany's Bundesbank reiterated its opposition to the plan. Draghi said the ECB would only help countries that signed up to and implemented strict policy conditions, with the euro zone's rescue fund also buying their bonds, and preferably with the IMF involved in designing and monitoring the conditions.

At a news conference, Draghi said: "Under appropriate conditions, we will have a fully effective backstop to prevent potentially destructive scenarios," and he indicated there are no limits on the size of the transactions. The bond buying program would not target specific bond yields. Spanish and Italian government bond yields have fallen significantly since Draghi said on August 2 that the ECB would buy bonds issued by Madrid and Rome. Again today, yields fell further after he announced the bond buying program.

Draghi also said the ECB was prepared to waive its senior creditor status on bonds it purchased - meaning it would be treated equally with private creditors in case of default. This was a little trick of the ECB during the Greek meltdown, where they basically jumped to the front of the line when it came time for payment. The central bank hopes that by removing private investors' concern about being paid back last in the event of a sovereign default, they will not be frightened by ECB intervention.

Draghi said all bond purchases would be "sterilized" by taking in an equivalent amount in deposits from banks to avoid any risk of inflation; think trash for bonds. The bond purchases have not started yet, and they might never get off the ground. Germany's constitutional court is scheduled to rule on the Euro Stabilization Mechanism rescue fund next week. Support for Mr. Draghi includes the German chancellor, Angela Merkel.

The German economy has already been dragged down by the downturn of the other euro-union countries. As much as Germans may complain about the less competitive indebted countries of the south, the costs to Germany of a euro collapse would be enormous. If Spain and Italy are shut out of the debt markets, the bailout funds are too small to bail them out. The cost of a bond buying program may be uncomfortable but the cost of a full fledged crisis and possible collapse of the euro-union is prohibitive.

Although the bond-buying program announced Thursday should reduce the pressure on Spain and Italy, if those countries choose to seek its protection, it will not solve the deep structural problems of the euro. The thinking is that it could buy time for the political leaders of the 17-nation euro zone to follow through on their past promises to back the currency with a more tightly integrated fiscal union and more disciplined oversight of national budgets.

And the bond buying plan is not guaranteed to succeed. The ECB deal is based on conditionality. Greece is the implied fate of anybody who dares to flout the rules. Greece hangs on the edge of being tossed from the euro-union while the country is increasingly being placed in an untenable position, which will almost certainly set it up for future failure. Part of the problem is whether Greece can be allowed to fail without destroying the union.

Marshall Auerback reports:

The eurozone creditors are now saying the Greek government must tighten the universal neoliberal screws even further by imposing a six day work week and perhaps reducing wages as well, as a condition for the Greeks getting another “bailout.” Of course, unemployment and underemployment in Greece are rising rapidly, so it is hard to see how extending the work week for the already employed can be the kind of “tough love” that will create an increase in the total number of jobs or improve the economy. In the creditor’s eyes, however, that is unimportant; the real problem is Greece’s dysfunctional culture of work and profligacy.

So the neoliberal policy solution for turning around the Greek economy is to improve the culture of work is to introduce a kind of debt peonage by taking the Greeks back to the 19th Century. And what happens when the six-day work week and wage reductions do not work, as they inevitably won’t? What comes next? Charles Dickens knew the answer — improve the culture of work by relaxing child labor laws to reduce wages further and/or privatize the Aegean islands, Delphi, and the Acropolis. No problem.

Greece, to be sure, has its share of self-inflicted economic problems, but austerity economics is pushing Greece into a death spiral. Europe is cutting its nose to spite its face as it converts one Eurozone economy after another into a barter state. The problem is that the renewed bond buying will be tied to the conditionality of yet more fiscal austerity, and Greece is being held up as the poster boy of what happens when you don’t comply with the conditions laid out by the ECB, or the Troika. In addressing the solvency issue, the ECB’s conditionality ironically will make the very “problem” of fiscal profligacy and higher government deficits much worse, as demand gets crushed by yet more austerity.

In other economic news, the Institute for Supply Management said its services index jumped to 53.7 last month from 52.6 in July. That beat economists' forecasts for a 52.5 reading. A reading above 50 indicates expansion in the sector. This follows a less than robust ISM manufacturing report on Tuesday.

Also today, we had a possible preview of tomorrow's jobs report. Initial claims for unemployment dropped by 12,000 last week to 365,000. ADP, the payroll processing company estimates nonfarm private businesses added 201,000 new jobs from July to August. The forecast for tomorrow's official jobs report is calling for an increase of about 150,000 jobs. The ADP report is not very good at actually predicting the official BLS report, but it suggests the number might be a little better than current guesses.

The data will also set the tone for monetary policy, ahead of the September 12-13 meeting of the Federal Reserve's policy board, the Federal Open Market Committee. Last week Fed chief Ben Bernanke laid out his case for the FOMC to take more action to boost the economy, citing the lack of progress this year on jobs and the rise in long-term joblessness.

Today the markets jumped higher on the prospect of the ECB passing out free money and the hope the Federal Reserve will pass out even more free money next week. Of course the buzz on the street from the central bank handouts is kind of like the buzz a little kid gets from eating too much sugar; it is fun for the moment but it wears off quickly. With respect to equity market levels, it doesn’t matter anymore. This isn’t the market we learned about in the past or what is described in the texts. Earnings don’t matter anymore, except for random stock picking, and then probably not very much after a few days or weeks of reduced stock prices. Structurally, the market only responds to liquidity and algo enthusiasm. What will sustain the markets moving forward? What will sustain the economy moving forward. Central bankers may be good at averting crashes; they may even be good at creating crashes, but what can they do to build sustainable economic growth? 

Wednesday, July 11, 2012 - Toodaloo San Berdoo

Toodaloo San Berdoo
-by Sinclair Noe




DOW – 48 = 12,604
SPX - .02 = 1341
NAS – 14 = 2887
10YR YLD un = 1.50%
OIL + .18 = 85.99
GOLD + 10.10 = 1577.60
SILV +.33 = 27.24
PLAT + 6.00 = 1435.00


The city council of San Bernardino, California, voted last night to file for bankruptcy, marking the third time in recent weeks a California city is seeking bankruptcy protection. The decision followed a report by city staff that said the city faced an imminent financial crisis. The report said the city had exhausted its reserves and projected that spending would exceed revenue by $45 million in the current fiscal year which started on July 1.


The city attorney general James Penman said San Bernardino's city officials had been submitting false accounting documents for 13 of the last 16 years in an effort to hide the real financial situation of the city. That period covers the tenure of multiple city managers and sets of elected officials, but it predates the  Acting City Manager.




San Bernardino will join the California communities of Stockton and Mammoth Lakes in bankruptcy court. Stockton failed on June 28th, after three months of talks with its creditors to obtain concessions to close its $26 million budget gap. Mammoth Lakes, a ski resort town of about 8,000 residents, last week filed for bankruptcy due to a nearly $43 million legal judgment against it.


San Bernardino has suffered from the housing crash and high unemployment. According to the report to its city council, the city "has reached a breaking point and faces the reality of deficient cash on hand to meet its contractual and debt obligations due in July 2012. The city has declared numerous fiscal emergencies based on fiscal circumstances and has negotiated and imposed concessions of $10 million per year and has reduced the workforce by 20 percent over the past four years." 


The report also said:"The city is still facing the possibility of insolvency due to a variety of issues including accounting errors, deficit spending, lack of revenue growth, and increases in pension and debt costs."


Chapter 9 bankruptcy would give San Bernardino an opportunity to restructure its finances, A bankruptcy filing would reopen negotiations on employee contracts but would not invalidate its pension payments. The Chapter 9 BK process would likely start in about 30 days and take about a year to 18 months. 




Interim City Manager Andrea Travis-Miller said San Bernardino is so broke it can’t make its August 15 payroll.  City Attorney James Penman told the council before the vote: “If the employees are not paid on Aug. 15, on Aug. 16 there will be a mass exodus of city employees. People are not going to work when they don’t get paid. Most of our employees will not show up to work. That would include police, fire, refuse, everybody. The city will virtually shut down.”




Municipal bond investors pretty much shrugged off the San Bernardino bankruptcy filing. California  muni funds have outperformed all municipal fund categories with the exception of high-yield munis. In the year to date, long California municipal funds have returned 6.61%. Muni national long funds have returned 5.69% over the same period, as have taxable multisector bond funds. The debt prices San Bernardino has to pay have held up fairly well after the vote to file for bankruptcy. The city’s lease-revenue bonds and special tax bonds are trading above 90 cents on the dollar.


That’s cheap compared to high quality bonds, but indicates the debt is far from collapsing and is still attracting a bid that’s nearly face value.






Meanwhile, unions representing civil servants in Scranton, Pa., filed suit yesterday after the mayor cut pay for police, firefighters, garbage collectors and other public workers to minimum wage, saying that was all the city could afford.  Unions representing police, fire and public workers in the city of 76,000 filed three lawsuits after the city defied a judge's order and issued paychecks Friday that paid 398 city employees at the minimum wage of $7.25 an hour. 




The lawsuits against Scranton Mayor Chris Doherty include one filed in federal court under the Fair Labor Standards Act accusing the city of failing to pay wages on time and failing to pay overtime. Another lawsuit seeks to hold the mayor in contempt for violating a judges order. Yet another alleges that benefits for disabled police and firefighters were cut without a hearing. For now, firefighters in Scranton will still rush into a burning building to save an elderly person or a child or you or me, and for that they will be paid less than the kid flipping burgers at McDonalds. 




Meanwhile, the city of Oakland  California in 1997 entered into the deal with Goldman Sachs to protect itself from potential interest rate spikes on city bonds used to fund police and firefighter pensions. Now, interest rates are low, and the city is paying the company an interest rate that is much higher than the prevailing rate Goldman pays Oakland.  The city has paid Goldman about $32 million more than it has received so far on the deal, according to labor and other community leaders, and may lose another $20 million before the investment expires in 2021.


City negotiators have been meeting Goldman for six months about reducing the estimated $15 million cost to terminate the agreement but have had no success. So, the Oakland City Council voted unanimously this week to stop doing business with Goldman Sachs if the company does not agree to cancel an investment deal that is costing the city $4 million this year. 


At the heart of the matter is an interest rate swap deal that the city entered with Goldman back in 1997. In its most basic form an interest rate swap involves two counterparties; one party is concerned that the interest rate will go up and the other is worried it will go down. To protect themselves the parties engage in a contract where, in effect, they cover each others’ risk; in this case, Oakland wanted to protect against higher interest rates so it locked in a fixed rate of 5.6% that it would pay to Goldman. In exchange, Goldman would pay the city a variable rate tied to Libor. 


Yes, Libor, the interest rate that was manipulated by various banks including Barclays. Yes, Libor, the rate at which banks borrow from one another, is one of the most important rates of the last decade and is the basis for roughly $800 trillion worth of loans and financial instruments and derivatives and   interest rate swaps. And yes, if banks are manipulating Libor rates lower then they themselves are borrowing money for less while their counterparties in interest rate swap contracts are stuck paying them much higher rates.


Back when Oakland first entered the deal at 5.6% on $187 million in bonds it was deemed a safe bet because it shielded the city from a potential hike in future rates. It worked out well for the city until the financial crisis hit and interest rates hit rock bottom.


The deal backfired as interest rates have dropped to record levels near 0% in the aftermath of the financial crisis when the Fed pushed rates down. So, now, Oakland pays 5.6% while Goldman Sachs pays right at zero percent; a little lopsided. Earlier, the  swap was a positive for the city. No word on how positive it was or remains to be for Goldman. Of course Goldman has been operating at greater advantage than Oakland or other municipalities. You may recall that the financial crisis resulted in big banks receiving bailouts; including Goldman Sachs. The federal government took Goldman's “troubled assets” off their hands and loaned them billions of dollars for free — even though it was the greed of the big banks that caused the crisis. Cities like Oakland haven’t been bailed out. Instead, Oakland is forced to hold toxic assets like rate swaps and hand over even more money to the banks.


The deal is costing Oakland about $4 million annually and could end up costing the city $20 million by 2021. So, the city council passed a resolution that authorizes the City Administrator to negotiate the termination of a swap agreement with Goldman. And the City Council says if Goldman refuses to terminate the deal (and waive all the termination fees) then the city of Oakland will never do business with the bank again in any capacity. It goes as far as to say that a refusal by Goldman to terminate will force it to use all good faith efforts. So far, Goldman seems unwilling to terminate the deal, or reducing the $15 million dollar cost of terminating the deal. There is no particular precedent that I've heard of. I don't know how they can completely boycott Goldman. If Goldman wants to buy Oakland municipal bonds in the open market, could the city stop that action?




It's not just a problem with Oakland. Some estimates figure banks are making more than $2.5 billion a year form municipalities and public agencies. 



Last year, Jefferson County, Alabama filed what was at the time, the largest municipal bankruptcy in American history. Why did they go broke? Because they signed a bad deal with JP Morgan Chase - and some other banks including Goldman Sachs and a handful of elected officials were corrupted; there is no other explanation for why they entered into such a rotten financial deal. The city needed a new sewer system - which was estimated to cost $250 million, but with interest rate swaps, the cost of the project  was pumped up to more than$3 billion. The bank sold the county a loan for the sewer that came with one of adjustable interest rates. The county would pay a low interest rate that it could afford for a few years and then the rates were adjusted and they were adjusted higher. And the city couldn't afford the payments on the loan, and so the banks tacked on fees, and pretty soon Jefferson County was busted.  So after furloughing city workers in Birmingham and they reduced the police force and they turned off some of the traffic lights, and they raised the water rates and some people can't afford water, and Jefferson County eventually filed for bankruptcy. 




Last year more than 35,000 taxpayers making more than $200,000 a year paid no federal income tax and 61 percent of those avoided tax for the same reason: their income consisted largely of interest on tax-exempt municipal bonds.


The Congressional Budget Office estimates that issuers receive about 80 percent of the value of the tax preference. Still, that means about 20 percent of the muni bond subsidy -- about $36 billion over the next five years -- is being captured by bondholders.


Nearly all of those bondholders are either for-profit corporations or individuals with high incomes. The higher your tax bracket, the greater the value of the tax preference, so it only makes sense to buy tax-free munis if you are in, or close to, the 35 percent federal tax bracket. You also need to be subject to US income taxes to make it worth your while.  There's no reason for nonprofits or foreign individuals or corporations to buy tax-free munis.


Is there a better way? Maybe. 


We can reform subsidies for municipal borrowing so that 100 percent of them actually go to municipalities, and so that municipal issuers have access to a broader bond market than one consisting of domestic corporations and wealthy individuals. We should also question whether we should subsidize municipal borrowing as much as we do.


There is a ready model for reform. For 2009 and 2010, states and municipalities were allowed to issue Build America Bonds. These bonds were taxable, but the federal government made 35% of the interest payments. These bonds can be sold to individuals, and investors who can’t take advantage of a tax preference, such as pension funds and foreign entities.


That program gave municipal governments access to a deeper and more liquid bond market. Because essentially any bond-market participant can purchase them, the limited set of buyers who  benefit from tax preferences can't use their special position to claim a portion of the subsidy. Why limit the field to wealthy Americans? Why not make a good deal for smaller investors who want to invest in their hometown?


In 2011, Congress let the Build America Bonds program expire but kept traditional tax-free munis.  Under both traditional muni bonds and Build America Bonds, subsidies are linked to the interest rate. That means issuers who must pay higher interest rates get more valuable subsidies. Perversely, the worse a municipality’s credit, the greater incentive it is given to borrow more money.


Instead of setting the subsidy as a percentage of interest, it should be a percentage of bond principal. There should also be a cap on bond yields at the time they are issued, so that issuers who can only borrow at high interest rates don’t get subsidized. If the markets are judging an issuer to be highly risky, we don’t want to encourage it to borrow more.


Congress could also further restrict the projects that can be financed with subsidized debt. Congress should target specific categories of investment that produce regional and national benefits. And it should especially tighten restrictions so that states can't use subsidized bonds to finance for-profit enterprises, as many places have done in recent years.


The size of the subsidy should also be evaluated. The level  of the Build America Bonds subsidy was chosen to match the top income tax rate, but that’s an arbitrary amount, and because some municipal bond buyers aren’t in the top bracket, it meant a bigger subsidy than for traditional munis. Given the long-term budget gap in Washington, a smaller subsidy is called for.


I don't know if Build America Bonds are the solution but its probably a good idea to start a discussion. The current system of financing municipalities is a mess. It is subject to corruption. I can't see any reason why the city of Oakland or Jefferson County needs to be involved in municipal finance. If we could eliminate the debt service, we could put a lot more money to practical purpose. The Fed has handed out hundreds of billions to banks, which turn around and scalp the municipalities – which is to say, the taxpayers. There has to be a better way.