Thursday, May 22, 2014 - A Heckuva Business Model

A Heckuva Business Model
by Sinclair Noe

DOW + 10 = 16,543
SPX + 4 = 1892
NAS + 22 = 4154
10 YR YLD + .02 = 2.55%
OIL - .31 = 103.76
GOLD + 1.80 = 1294.70
SILV + .10 = 19.59

Yesterday we told you Russia and China had signed a 30 year, $400 billion dollar deal for Russia to deliver natural gas to China. Today, both countries vetoed a United Nations Security Council Resolution seeking to refer Syria to the International Criminal Court for possible war crimes. In the short-term, the Russia-China gas deal won’t have a big impact. The deal will not be in place until 2018 and even then will only see Russia selling a fraction of its gas exports to China every year, exports to the EU could still well be two to four times the size.

The economic links between Russia and Europe will continue to be significant and they will continue to be reliant on each other when it comes to energy; the former to sell the latter to buy, but this link gives an advantage to Russia, especially when the weather turns cold. At least symbolically the deal highlights Russia’s desire to move away from links with Europe. Combine this with Europe’s desire to increase energy security and the relations between the two sides could become increasingly cold and distant. Although, some countries due to geographical proximity, such as Bulgaria or Hungary; or due to long standing economic links, such as Germany - will surely continue to have good relationships with Russia. The entire Ukraine crisis has brought the return of a Cold War, and the gas deal sets up an East and West Economic Bloc.

It also raises questions over future tie ups between Russia and China. Areas such as payments systems, broader financial markets, transportation and machinery have all been touted as sectors for potential cooperation between the two countries. Again while a long term issue, such ties up may concern the West since Russia and China are currently reliant on their exports in many of these areas. Both the EU and US will need to figure a clearer policy for how to deal with such changes.

Unrest continues in Ukraine. BBC reports at least 11 Ukrainian soldiers were killed during an attack on a government checkpoint in eastern Ukraine. The attackers were described as heavily armed terrorists. Russia has claimed that it was pulling back troops from the Ukrainian border, but that has not been confirmed by satellite photos.

Thailand’s army chief went on television today to announce a military coup, after two attempts to negotiate an end to political impasse failed. The country’s Constitution was “temporarily suspended,” and the military said it terminated the caretaker government but said it expected the nation’s Senate, courts and independent organizations to function normally. The military imposed a nationwide curfew, and ordered all street protesters to leave their rallying sites.

In economic news, the National Association of Realtors reports existing home sales increased 1.3% to an annual rate of 4.65 million units, marking only the second gain in sales in nine months. Sales remain down 15% from a peak of 5.38 million units hit in July. Compared to April last year, sales fell 6.8%.The inventory of unsold homes on the market increased 6.5% from a year-ago to 2.29 million in April. That was the highest level since August 2012. The median home price rose 5.2%, the slowest pace since March 2012.

In this cycle we’ve had enormous price increases before we had the demand, which was a function of institutional buying of homes, which pushed prices higher. One thing we should have learned about housing is that when prices start rising, there is a herd mentality that kicks in. It wasn’t just institutional buying, it was a combination of events that swirled around institutional buying. The institutional buyer bought up distressed properties, resulting in fewer distressed inventory, add in people who were locked into their homes by negative equity or low equity;  and for many would-be buyers, it’s just tough to get a decent mortgage, or any mortgage at all.

This doesn’t mean banks aren’t lending – they are; it turns out that banks are ready, willing, and able to lend to small businesses, but you might not like the deal. Typical interest rates are about 125%.  Subprime business lending, the industry prefers to be called “alternative”, has swelled to more than $3 billion a year; that’s twice the volume of small loans guaranteed by the Small Business Administration. Wall Street banks are helping the industry expand by lending originators money. They’re starting to package the loans into securities that can be sold to investors, just as they did for subprime-mortgage lenders. It’s a heckuva business model.

Manufacturing activity picked up in May; Markit's "flash" US manufacturing purchasing managers index rose to 56.2 from 55.4 in April.

New applications for unemployment benefits rose sharply in mid-May, reversing a big drop earlier in the month that put initial claims at a seven-year low. The number of people who applied for new benefits climbed by 28,000 to 326,000 in the week ended May 17. That number might grow in the coming weeks thanks to HP.

Hewlett Packard announced earnings after the close, sales fell, revenue fell, but profits were higher, and they will cut an additional 11,000 jobs, bringing the total for outstanding job cuts to 16,000.  It’s a heckuva business model.

Yesterday, William Dudley, the president of the New York Fed gave a speech to the Regional Economic Press Briefing in New York, and he said: “There have been significant and long-lasting changes to the nature of work. As a result, many middle-skilled workers displaced during the recession are likely to find that their old jobs will never come back. Furthermore, workers are increasingly facing higher skill requirements in order to land a good job. These dynamics in the labor market present a host of challenges for the region to address. However one thing is clear: workers will need more education, training and skills to take full advantage of the types of job opportunities being created in our region, as well as across the nation.”

No doubt education is important. More education and skills will not stop your fall but it might slow it down. And a point that Mr. Dudley failed to grasp, or at least communicate is that a significant percentage of corporate profits have relied upon the widespread loss of worker economic share over the past few decades.

If you have bought or sold on eBay in the past few months, change your password and monitor your financial information. The company says hackers attacked between late February and early March with login credentials obtained from "a small number" of employees. They then accessed a database containing all user records and copied "a large part" of those credentials.

The hackers stole email addresses, encrypted passwords, birth dates, mailing addresses and other information, though no financial data, nor PayPal databases were compromised. The eBay breach would be larger than the one Target Corp disclosed in December, which included some 40 million payment card numbers and another 70 million customer records. Why are we just hearing about the eBay hack now? That is a very good question and so far eBay hasn’t provided a good answer.

We’ve noted many times that bankers have a get out of jail card. This week, Credit Suisse entered a criminal guilty plea in New York for its role in an ongoing tax evasion scheme, but that was a corporate entity, and no actual human bankers went to jail; in fact, the CEO and Chairman get to keep their jobs; but today we note that the handcuffs have been slapped on a banker, the former head of investment banking for JPMorgan Chase, in China.

You may recall the recent allegations against JPMorgan in China. Jamie Dimon had a clever little business development strategy to hire the children of Chinese politicians, to win support for JPMorgan banking activities in China; it’s a heckuva business model, except apparently the SEC’s antibribery unit thinks this might be bribery and thus a violation of the Foreign Corrupt Practices Act; except the SEC was not behind today’s arrest, and we all know that US law enforcement and regulators would never actually arrest a banker. However, finding jobs for the children of China’s elite in exchange for bank underwriting is apparently illegal in China, too.  And in China they have this strange custom of arresting people who break the law, even if work for JPMorgan.

In case you missed it, this week’s criminal settlement with Credit Suisse marked a turning point for law enforcement in dealing with the big banks. The Department of Justice says it proves they will go after the big banks and slap them with felonies convictions, even though they get misdemeanor punishment. Well, the proof is in the putting.

And now we have a new case that will show whether there is really any crackdown on wrongdoing, specifically money laundering; regulators are investigating Charles Schwab Corp and Bank of America Corp's Merrill Lynch brokerage over whether the brokerages missed red flags that could indicate attempts to move money illicitly or to feed proceeds from illegal activities into the financial system. The SEC is probing Schwab and Merrill Lynch for violations of anti-money laundering rules that require the brokerages to know their customers.

Treasury Undersecretary for Terrorism and Financial Intelligence David Cohen began urging regulators two years ago to make sure financial institutions are identifying the true beneficial owners of their accounts. Cohen's exhortations came amid concerns that bad actors, such as drug cartel members and terrorists, are growing more creative in their attempts to secretly transfer tainted funds.

The SEC's investigation so far has found Charles Schwab and Merrill did not pay close enough attention to their clients' true identities, and accepted shell companies and individuals with fake addresses as clients. In both cases, some of the accounts, whose ownership the brokerages did not adequately investigate, were eventually linked to drug cartels. The investigation is not yet complete, and the only thing we know with certainty is that it’s a heckuva business model.

Tuesday, May 20, 2014 - Protected Species

Protected Species
by Sinclair Noe

DOW – 137 = 16,374
SPX -12 = 1872
NAS – 28 = 4096
10 YR YLD - .02 = 2.51%
OIL + .87 = 102.98
GOLD + 1.70 = 1295.30
SILV + .05 = 19.49

Today is Tuesday and that means that General Motors has announced another recall; this time 2.6 million more cars. Last week, GM recalled 3 million vehicles. So far this year, GM has announced 29 recalls affecting more than 15 million cars globally. The list of recalled vehicles is long. It’s easier to list the vehicles that haven’t been recalled; they have recalled 58 versions of Chevrolet and GMC pickups.

Last week the Dow hit a record high; since then it has been floundering. For the fourth straight session, the Nasdaq Composite has posted more 52-week lows than 52-week highs; 55 lows versus 38 highs. The Russell 2000 Index of small and mid-cap stocks hit a high on March 4^th and since then it has dropped almost 10%.

Meanwhile, interest rates have been moving steadily lower despite winding down of large scale asset purchases under the Fed’s quantitative easing, and the talk about raising interest rates at some point down the road. With yields on the 10-yr Treasury note dipping down around 2.5%, that means somebody is buying Treasuries, but if not the Fed, then who?

Well, it’s certainly not Russia. Putin sold off more than $100 billion in Treasuries in March; he was probably expecting Treasury prices to tumble, but that didn’t happen. The most likely buyer is Belgium; from November of last year through January 2014, Belgium bought approximately $142 billion in US Treasuries, which is quite a bit considering the Belgian GDP is about $480 billion; so their bond buys were equal to about 30% of GDP.

As a member of the Eurozone, Belgium can’t just print new money. So, something is rotten. Or maybe the Fed has opened up a branch office in Antwerp.

Anyway, Putin is in China today to talk up the virtues of Russian natural gas. Putin met with Chinese President Xi Jinping at a start of a two-day meeting on Asian security with leaders from Iran and Central Asia. Putin is hoping to extend his country's dealings with Asia and diversify markets for its gas, which now goes mostly to Europe. Russia has been negotiating for more than a decade on a proposed 30-year deal to supply gas to China. Officials said they hoped to complete work in time to sign a contract while Putin is in Shanghai, but they have not yet announced a signed agreement. Putin told Chinese reporters ahead of his visit that China-Russia cooperation had reached an all-time high.

Russia is worried about its European gas market, seeing lackluster European demand and political efforts, intensified since the Ukrainian crisis, to diversify away from Russian gas constraining future sales to the West. At the same time, the shale gas phenomenon, with possible US and Canadian liquid natural gas exports to come, has Moscow concerned about what prices it can hope to attain from the European market. Developing new, potentially lucrative markets in the east seems to be the answer to Russia’s European gas concerns.

China also feels a new impetus for a deal. Despite a slowing of the domestic economy, future demand for energy, the key to both growth and political stability, will be robust. Efforts to develop China’s domestic shale resources are promising, but are unlikely to produce consequential volumes until the next decade. Meanwhile, China has been meeting growing energy consumption with coal powered plants, and they are literally choking on that decision, as the air quality has been nearly destroyed.

Tomorrow we will get the minutes of the last Federal Reserve FOMC meeting. Today we had Fed heads giving speeches. William Dudley, the president of the New York Fed is saying the Fed will take its time raising interest rates.  Noting both market and Fed expectations that the first hike will come some time near the middle of 2015, Dudley said, “if the economy is stronger than expected, causing the excess slack in the labor market to be absorbed sooner and inflation to rise more quickly than forecasted, then lift-off is likely to be pulled forward in time. If, instead, economic growth disappoints, inflation stays unusually low and the labor market continues to exhibit evidence of considerable excess slack, then lift-off will likely be pushed back in time.”

As for the over $4 trillion worth of bonds on its balance sheet, Dudley expects them to be reduced via “automatic pilot”; in other words, as Treasury securities mature and mortgages are repaid. Dudley offered his two cents on why the housing sector’s contribution to the economy has “stalled out” over the past few quarters.  While he said some decline in activity was to be expected following the jump in mortgage rates last year, “the extent of the slowdown has surprised me given that the recent pace of housing starts, roughly 1 million per year, is far below what is consistent with the economy’s underlying demographics.”

Dudley said mortgage credit is still unavailable to borrowers with lower credit scores. Also, student debt has delayed the entry of new first-time home buyers; that could make it harder even for existing homeowners to sell their homes and trade up, slowing the traditional turnover of the housing market. Dudley said he expects the housing recovery to continue, “the pace will likely be slow, especially relative to past economic recoveries.”

The online real estate site, Zillow reports 18.8% of US homeowners with a mortgage, or 9.7 million households, were underwater on their mortgages at the end of the first quarter. That's an improvement from the end of last year when this figure was 19.4%, and it's a large improvement from a peak of 31.4% in 2012, but it shows that negative equity is still an issue in the housing market.

What's more, there is an additional 10 million households that have 20% or less equity in their homes. For those homeowners, it would be difficult to sell without coming up with some money to cover the broker fees, closing costs and the down payment for the next home.

European Union regulators have charged banks JPMorgan, HSBC and Credit Agricole with colluding to manipulate the price of financial products linked to interest rates.

The European Commission's regulator said the banks will now have a chance to respond to the preliminary findings. If the Commission ultimately concludes they have broken the law, it can impose a fine of up to 10% of their annual revenue. In December 2013, the Commission levied fines totaling $1.4 billion on Barclays, Deutsche Bank, RBS and Societe Generale as part of the same case, which covers financial derivatives linked to a benchmark interest rate called Euribor in the period 2005-2008. Barclays escaped fines for having notified the Commission of the existence of the cartel, and the others were granted a reduction in their fine for cooperating in a settlement.

Late yesterday, Credit Suisse entered a guilty plea for conspiring to help US customers evade taxes, the first such guilty plea by a major financial institution in years. Today Credit Suisse shares rose almost 1%. Apparently a felony conviction is a good thing. And why not? Top bank executives will get to keep their jobs, the bank can pin the whole thing on a handful of underlings, and it won't have to give up a list of client names to the government. Credit Suisse will have to let an independent monitor keep an eye on it, but that's a minor inconvenience at worst. The guilty plea could cost the bank some clients here and there, but investors and analysts are betting there won't be much impact. The most painful part of the deal, the $2.6 billion in fines, is manageable, less than one quarter's revenue.

For the most part, the mainstream media is dutifully accepting the spin of the Department of Justice, that this case is significant by virtue of being the first plea of this sort made by a bank in over two decades. The fact that those intervening years saw regulators generally take a very hands off approach to banks, and that we had a global financial crisis with no measures of this sort taken against the perps somehow escapes mention.

Let me return to one critical issue: why no individuals were prosecuted or even fined. This case, like so many we have discussed, seems ideally made for at least a civil action under Sarbanes Oxley against the CEO and CFO, since they must certify the adequacy of internal controls. The most charitable coloration you can put on what looks an awful lot like obstruction of justice (although Credit Suisse was not charged with that) was that it was a failure of internal controls. And Sarbanes Oxley is designed so that a civil action can easily tee up a criminal case on the same control deficiencies.

Credit Suisse was in many ways the perfect major financial institution from which to demand a guilty plea. Although its investment banking and wealth management operations are global, the commercial banking operation in the United States is largely confined to its New York branch. It does not own a subsidiary in this country providing bank services to local customers, so it really only had to negotiate with the New York authorities and the federal government to resolve the case. That meant the effort to mitigate potential collateral consequences of a guilty plea was confined to just a few agencies. So, if you think the Credit Suisse case will become the template to go after American banks, well, yeah, that’s not going to happen. The banking class remains a protected species. 

Thursday, May 15, 2014 - A Calm Port in a Stormy World

A Calm Port in a Stormy World

by Sinclair Noe

DOW – 167 = 16,446
SPX – 17 = 1870
NAS – 31 = 4069
10 YR YLD - .04 = 2.50%
OIL - .81 = 101.56
GOLD – 8.90 = 1297.80
SILV - .29 = 19.56

Today, it seems there is a lot going on. Let’s start with international hotspots.

Turks are angry following a deadly mine explosion that has killed at least 300 miners and trapped possibly 100 more; thousands of workers joined a protest strike, demonstrators clashed with security forces, and the discontent threatens the government. An aide to the prime minister was photographed assaulting a protester and there are claims that Prime Minister Erdogan himself struck a teenage girl; that after he was forced to flee an angry crowd and seek safety in a nearby grocery store. Turkish trade unions held a one-day strike over safety standards in the mining industry. Security forces deployed tear gas and water canons against protesters.

Meanwhile, reports of dozens of deaths from an explosion along the border between Syria and Turkey. Also, further allegations of ongoing chemical attacks by the Syrian government. Speaking in London today, Secretary of State John Kerry announced the US, Britain, and European and Arab states are increasing efforts to support rebels fighting to overthrow President Assad. Assad still has the backing of Russia, and that makes already tense relations with Russia even more edgy.

Fears of a civil war in Ukraine are mounting. Nobody wants to jump in with troops, and so there are clandestine forays by unidentified groups or squads of soldiers. And the major powers are only explicit with sanctions. Today, Russia announced it will halt the export of rocket engines crucial to US military defense and space programs. It must be very uncomfortable on the International Space Station these days.

Anti-Chinese sentiment has been running high in Vietnam ever since Beijing deployed an oil rig into disputed waters in the South China Sea on May 1st. There have been encounters including ramming and exchanges of water cannon between Chinese vessels operating near the rig and boats from Vietnam, which wants China out of the area. Today, Cambodia reports hundreds of Chinese nationals had poured across the border from Vietnam to escape riots.

Also, Japan’s Prime Minister, Shinzo Abe, has called for a review of how Japan interprets its pacifist constitution to allow its military to participate in conflicts beyond its borders for the first time since the end of the second world war; this in response to a growing conflict between China and Japan over islands claimed by each country; of course, it’s not just islands but the oil reserves around the islands.

Meanwhile, China issued a bunch of economic data this week, and it mostly points to a real estate slump; home sales fell 18%; housing starts were scaled back by 25%. Moody’s Analytics estimates that the building, sale and outfitting of apartments accounted for 23% of Chinese gross domestic product last year. That is higher than in the US, Spain or Ireland at the peaks of their housing bubbles. The scale of China’s building boom and the country’s reliance on infrastructure investment for growth is unprecedented. In just two years, from 2011 to 2012, China produced more cement than the US did in the entire 20th century, and it all seems to be on shaky ground these days. Each attempt to rein in China’s $25 trillion credit bubble seems to trigger wider tremors.

Brazil has sent army troops to Recife, the capital of the northeastern state of Pernambuco, after strikes lead to riots. State police walked off the job Tuesday. Schools and universities also closed down because of concerns for student safety. Today, further protests in Sao Paolo and Rio de Janeiro drew tens of thousands to the streets. The protests are centered on cities that will host the upcoming World Cup, the quadrennial global soccer championship games. Huge anti-government protests across Brazil last year overshadowed the Confederations Cup, a warm-up tournament for the World Cup. Some of the demonstrations saw clashes between activists and police, and at least six people were killed.

Many Brazilians are angry at the billions spent to host the World Cup. Protesters have said the government should focus spending instead on improving Brazil's woeful health, education, security, housing, and infrastructure systems. The World Cup starts in less than 30 days, and the whole world will be watching.

In one week, Europeans will elect a European Parliament. It’s the second biggest election in the world, after India. Voters look set to choose more assorted extremists, anti-Europeans and oddballs than ever. The Euroland economy is going nowhere, and with the razor thin exception of Germany, most countries are seeing economic contraction; that tends to lead to strange election results.

There are other hotspots around the World. The president of Yemen has declared all-out war on Al Qaeda militants and army troops are now trying to dislodge Al Qaeda from the Arabian Peninsula. Political violence returned to Bangkok Thailand, and the Thai army killed a handful of protesters and threatened more military action if the protests continue. And of course, the Nigerian crazies, Boko Haram, and the kidnapping of hundreds of schoolgirls. And of course, all the old seething conflicts that haven’t been resolved. And don’t forget, the US is still at war in Afghanistan. I know, it’s easy to forget. Apparently, it’s even easier to forget the veterans that have served our country.

Today, Secretary of Veterans Affairs, General Eric Shinseki went before the Senate Veterans Committee to explain the mess that is the VA; this following revelations that as many as 40 veterans died while waiting for medical care at the VA facility in Phoenix.

Since the allegations arose last month that veterans were forced to wait months for appointments at the Phoenix VA medical center and that VA officials were covering up the problem, Shinseki said he has asked the VA's inspector general to investigate. He said he has also launched an intense investigation of scheduling practices at the VA's other 151 medical centers. Shinseki said he was “mad as hell” and the various Senators all acted very indignant. Of course, it wasn’t very believable theatre.

One of the documents brought forth today was an internal VA memo, written in 2008 by a team of VA managers, listing 25 ways that VA scheduling clerks were cooking the books to make it appear that veterans waiting for medical care actually were being seen on time, when in fact they were being made to wait weeks or months.

And then, 2 years ago, the Government Accountability Office reported that VA schedulers were fudging wait times for veterans seeking outpatient care and avoiding using the electronic waitlist as required. The GAO report includes a response from Shinseki's chief of staff at the time, writing that the VA has "proactively taken steps in response to GAO's findings." Clearly that didn’t happen.

Meanwhile, Southern California is on fire. Actually nine fires are burning in the greater San Diego area and they have already destroyed more than 10,000 acres, forcing evacuation of about 125,000 residents. California Governor Jerry Brown has declared a state of emergency to free up resources. It’s hot, it’s dry, and it’s just the start of the fire season.

The 2014 fire season is repeating a pattern of destruction established over the past decade by a combination of high temperatures, parched vegetation and more people living in wooded areas. Fires feeding on plentiful dry grass, brush and hardwood are requiring more personnel and money to bring them under control. More than twice as many acres burned across the US through May 9 this year than during the same period in 2013.

Last week, 96% of California was considered to be under “severe” or worse drought conditions, with about 4% of the southeastern tip of the state still in “moderate” drought conditions. A year ago, only 46% of the state suffered from “severe” or worse conditions. As of today, the National Drought Mitigation Center reports severe drought conditions now engulf 100% of California.

Meanwhile, former Treasury Secretary Tim Geithner is trying to polish his tarnished image; he’s on a book tour peddling the notion that the Wall Street bailout was a huge success. And while it might be argued it prevented a Great Depression, it is delusional to consider it a success. It was at best an experiment that did not result in a worse catastrophe. It did little or nothing for the tens of millions of Americans who lost billions of dollars in home equity and savings, and the millions more who lost their jobs. The toll was greatest on the poor and the middle class. Nor have reforms been enacted that will help the middle class and the poor the next time Wall Street implodes.

Economic data today showed industrial production in the US unexpectedly declined in April, held back by a plunge in utilities as temperatures warmed and a broad-based decrease in manufacturing. That contrasted with a higher-than-forecast reading on the Fed Bank of New York’s gauge of regional manufacturing, which climbed to 19.01 this month, from 1.29 in April.

Initial claims for state unemployment benefits declined 24,000 to a seasonally adjusted 297,000 last week. It was the lowest reading since May 2007.

Consumer prices recorded their largest increase in 10 months in April. The Consumer Price Index increased 0.3% last month as food prices rose for a fourth consecutive month and the cost of gasoline surged. In the 12 months through April, consumer prices rose 2.0%. Stripping out food and energy prices, the so-called core CPI rose 0.2% after advancing by the same margin in March. In the 12 months through April, the core CPI increased 1.8%, the biggest gain since August last year.

Normally you might expect higher inflation numbers to result in lower bond prices, which means bond yields would move higher; not today. The yield on the 10-year Treasury note dipped below 2.5% intraday. Of course, Treasuries are considered a safe haven investment, and it seems a lot of people are looking for a calm port in a stormy world.

Thursday, March 20, 2014 - Stress Tests and Such

Stress Tests and Such
by Sinclair Noe

DOW + 108 = 16331
SPX + 11 = 1872
NAS + 11 = 4319
10 YR YLD un = 2.77%
OIL - .27 = 98.63
GOLD – 2.10 = 1329.50
SILV - .34 = 20.37

More sanctions for and from Russia; President Obama today expanded sanctions against Putin’s inner circle, now banning visas and freezing assets of 20; the blacklist now includes a commodity broker with a brokerage based in Switzerland, plus Bank Rossiya with about $10 billion in assets.

In response, the Russian Duma, the lower house of parliament ratified the annexation of Crimea, and Putin announced sanctions against US oligarchs, including Senators John McCain and Harry Reid, and House Speaker John Boehner. McCain said he would have to cancel his plans for Spring break in Siberia.

There is an EU summit underway, and it remains to be seen if European leaders will get tough with sanctions. German Chancellor Angela Merkel has been talking tough but the Euro-economy is still fragile, and it is doubtful sanctions will serve as a strong deterrent. This is not to say that sanctions won’t have an effect. Some of Russia's largest companies are registered abroad where they may benefit from lower tax rates.

You might not have caught this next bit of news, after all there was a lot going on today with the Russian sanctions and the breaking news on the missing plane and the basketball brackets and such; anyway, in Florida today, after talking about sanctions, President Obama called for legislation requiring equal pay for equal work.

Obama said: “Women with college degrees may earn hundreds of thousands of dollars less over the course of her career than a man at the same educational level, and that’s wrong. This isn’t 1958 -- it’s 2014.”

This is clearly a blatant attempt to draw in more female voters in the mid-term elections; still it’s true.

California is facing wildfires "outside of any normal bounds" as a historic drought turns drying brush and trees into a perfect tinderbox. Fire officals say the state recorded 665 wildfires from the start of the year through March 8, about three times the average of 225 for this time of year. Cal Fire officials warn that each day without heavy rain deepened the risks of a catastrophic fire season and made it hard to deal with more wildfires if and when they broke out. And the fires are bigger.

Even before this year's drought, forest officials were reporting a longer fire season, and more catastrophic mega-fires, in California and other western states. Half of the worst fires in recorded Californian history have occurred since 2002. This is usually the time of year when much of the state is greening up. We haven't even got into the months that historically are the worst in California – late August, September and October – so that's a big red flag right there.

The number of Americans filing for jobless benefits hovered near three-month lows last week. Initial claims for state unemployment aid increased 5,000 to a seasonally adjusted 320,000 last week.

In a separate report, the Philadelphia Federal Reserve Bank said its business activity index rebounded to 9.0 in March from -6.3 in February. Any reading above zero indicates expansion in the region's manufacturing. There was a rebound in new and unfilled orders at factories in the region. Shipments also bounced back, but inventories fell. Employers opted to increase hours for existing workers rather than expand payrolls.

The National Association of Realtors said existing home sales slipped 0.4% to an annual rate of 4.60 million units. That was the lowest level since July 2012. Inventory levels are low, while prices have been moving higher. The median price for a previously owned home rose 9.1% in February from a year earlier.

The Conference Board's leading economic index rose 0.5% in February, after a 0.1% rise in January and a 0.1% decline in December.

The Federal Reserve submitted the stress test results on the 30 biggest US banks; 29 passed, one failed. Zions Bank does not have enough capital reserves; this is not a surprise; Zions is resubmitting its capital plan after taking a charge on bank trust preferred securities which Zions tried to claim as Tier 1 capital, but the Fed did not accept that.

Anyway, the Fed figures that if the economy falls off another cliff, the banks would lose $501 billion, but they would be able to survive. The Fed defines falling off a cliff as a bad recession where unemployment spikes to 11.25%, the stock market drops 50%, and home prices drop 25%. Most sane people would call that a depression.

Previous stress tests were used to reassure investors that the big banks were not a hot mess and were financially strong, even in tough times. The problem is that the tests aren’t very realistic. Unfortunately, the Fed’s approach ignores a lot of the horrible things that actually happen in nasty downturns. For example, banks’ borrowing costs tend to rise, killing profits that could offset their losses; trouble at one bank can spread as investors wonder which others will be affected; credit freezes can force financial institutions to sell assets at a loss, setting in motion downward spirals in which falling prices and banks’ woes reinforce each other. If you start thinking about all those things, we’d be lucky if one bank could pass the test. Of course, that wouldn’t inspire much confidence, and so…

Remember not so long ago when the markets were upset about emerging markets and a slowdown in China? Just in case you forgot, Morgan Stanley has just issued a report on China. Here are some of the key points:

Morgan Stanley analysts…, “believe China’s twin excesses (excessive investment funded by excessive debt) will inevitably unwind, causing a substantial slowdown in China’s economy, significantly below market expectations. In recent weeks, a trip to the region and further research into China’s shadow banking system have convinced Morgan Stanley analysts  that China is approaching its “Minsky Moment,” which increases the chances of a disorderly unwind of China’s excesses. (that reference to “Minsky moment” refers to an economist named Hyman Minsky, from the 1930, who basically claims that the more you prop up an economy, the more likely it will eventually become unstable) The efficiency with which credit generates economic activity is already deteriorating, as more investments are made in non-productive projects and more debt is being used to repay old debts.

Based on the Morgan Stanley analysis, their baseline case is that China may slow from the current level of 7.7% Gross Domestic Product (GDP) growth to 5.0% over the next two years. A disorderly unwind could take Chinese growth down to 4% in a shorter time frame with potentially disastrous consequences for levered Chinese assets (banks, property) and the entire commodity supply chain (commodity stocks, equipment stocks, commodity-sensitive countries and their currencies).

The consensus is more optimistic and expects China’s economy to grow by 7.4% in 2014 and 7.2% in 2015. Most market participants have concluded that the Chinese economy, despite its excesses, will slow only moderately as the government successfully manages to “soft-land” the credit and investment boom and that, as a result, the impact on global GDP growth could be moderate and is not likely to derail the global developed-market-led expansion. However, one of the more controversial conclusions of their analysis is that global economic growth could be impacted severely enough to cause a global earnings recession.

They suspect China’s economy has arrived at that unstable state where speculative and Ponzi finance appear to dominate. From a macroeconomic perspective, very few economies have ever created as much debt as China has in the past five years. China’s private sector debt has increased from 115% of GDP in 2007 to 193% at the end of 2013. That 80% increase over five years compares to the U.S.’s 26% in 2000-2005. In recent years, only Spain and Ireland have achieved debt growth greater than China’s. Every year, China is now adding $2.5 trillion of private sector debt to a $9.7 trillion GDP.

There is evidence that this debt growth has become excessive and non-productive. It now takes 4 renminbi (RMB) of debt to create 1 renminbi of GDP growth from a nearly 1:1 ratio in the early and mid-2000s. After the massive stimulus and more than doubling of new bank loans in 2009, the government attempted to stabilize credit growth, but the growth of the shadow banking system exploded instead. Shadow banking now accounts for more than a fifth of total credit in China—or about 40% of GDP from a base of 12% just five years ago. The shadow banking system funnels credit to borrowers who can no longer get loans from the formal banking sector.

Defaults or near-defaults have begun to occur with regularity over the past three months and are likely to pick up in quantity significantly over the next year. As it is becoming more clear that investors may not get all of their money back, interest rates on trust products, wealth management products (WMPs), corporate bonds, and bank loans have risen by roughly 200 basis points in the last year.

The unwind of this credit boom is likely in progress, and they expect it to pick up speed over the coming months and quarters. It will likely involve a steady drip of defaults and near-defaults as insolvent borrowers finally become illiquid. Market rates for all assets except central government bonds and central bank bills will likely continue to rise, reflecting increasing market fears of default by shaky borrowers. Asset values will likely begin to deteriorate as stressed borrowers attempt to sell assets to stay afloat. As a result, banks and other financial entities could begin to increase provisioning for bad debts and to reduce credit availability by gradually tightening credit standards. This could lead to a credit crunch where credit to the economy is choked off for all but the safest borrowers. Most other analyses concludes that China could slow more than currently expected by the consensus, but that the global economy is well-positioned to withstand such a slowdown. And the Morgan Stanley report concludes that they are  a bit more pessimistic.

Friday, January 24, 2014 - Bulls, Bears, and Bonuses

Bulls, Bears, and Bonuses

by Sinclair Noe

DOW – 318 = 15,879
SPX – 38 = 1790
NAS – 90 = 4128
10 YR YLD - .04 = 2.73%
OIL - .41 = 96.91
GOLD + 4.40 = 1270.00
SILV - .11 = 20.01

The Dow has fallen every day this week, leaving it down more than 3%. That decline is the Dow's worst weekly performance since mid-May 2012. Meanwhile, the S&P 500 is down 2.5% since last Friday. That's the index's worst weekly slide since early November 2012.

All of the sudden, everybody seemed concerned about political and economic problems in Turkey, Argentina, and of course, China. The Turkish lira hit a record low and the South African rand fell to five-year low against the dollar. The Argentine peso had its sharpest decline in 12 years, going back to the 2002 financial crisis in that country; and the government abandoned its long standing policy of intervening to support the peso currency. Such moves are crucial factors for big, institutional foreign investors because exchange rate losses can easily wipe out any gains in stocks and bonds of emerging countries.

Right now, the losses haven’t turned into a rout, but there is concern that the turn may push big institutional investors to cut losses and run as the effect of falling currencies becomes too painful to bear. Every emerging market crisis is first-and-foremost a currency crisis. For example, South African government debt was slightly positive in rand terms in 2013. But in dollars terms, it lost more than 18%. Fund tracker EPFR estimates emerging equity and bond funds have seen outflows of almost $5 billion so far this year, on top of $58 billion of losses seen in 2013. EM equity funds have had 13 consecutive weeks of outflows, the longest run in 11 years.

What we haven't seen in emerging markets is major currency devaluation, a run on government debt or ratings downgrades. Any combination of those would suggest a major move where developing countries could experience sudden stops in their access to global capital, or some event that throws economies into a balance of payments or financial crisis. What we have seen and might continue to see is emerging market currencies falling, possibly big drops, as the yield on the 10 year Treasury note moves higher; which is expected to happen as the Fed cuts back QE3.

For several years, the world’s emerging markets seemed to be the main beneficiaries of two global trends: very rapid growth in China and the Federal Reserve’s various accommodative monetary policies, which injected huge amounts of capital into global markets. Since the Fed officially announced in December that it would ease its bond-buying stimulus, investors in emerging markets have been cautious. There are fears that rising interest rates will choke off growth in countries dependent on foreign lenders.

And for many years emerging markets have been able to sell resources to China, as China emerged as the world’s biggest producer and biggest market for everything from steel to coal to cars, the demand from China for raw materials soared year after year. Investors have committed tens of billions of dollars to emerging market projects aimed at meeting China’s voracious demand, and now Chinese demand is softening. Chinese economic growth slowed to 7.7 percent last year and the latest surveys of manufacturers in China show that with the exception of a few exporters, expectations about future sales are falling. The result in recent days have been waves of cash flowing out of emerging markets and into industrialized countries, notably the United States; but the  money has been going into the safe haven of Treasuries, rather than into the stock market.

It was just a few days ago that most people were bullish. Even the Fed’s taper at the December meeting was hailed as proof that the economy was improving. Earnings season has been less than exciting but we haven’t had massive misses, except for maybe IBM, Best Buy, Coach, Intel, Citigroup, and a few others; but nothing out of the norm. For the most part, Wall Street continues to pump up expectations, and there are still a few high flyers like Netflix, even if they are selling at 326 times earnings with almost zero in actual free cash flow. The Fed FOMC meets next week to determine their next moves on monetary policy and they are expected to continue with more tapering. Equities on Wall Street seem to have been shaken by the same fears that have hit the global equity markets; or maybe that’s just an excuse for a long overdue pullback. Your guess is as good as anybody.

In a TV interview today, Attorney General Eric Holder said no American financial institution is too large to indict and no bank executive immune from criminal prosecution. Holder cited the case of JPMorgan, which in November agreed to a civil settlement under which it would pay $13 billion to end a series of government investigations into its sales of toxic mortgage backed securities. It was an interesting case for Holder to cite because you may recall JPMorgan was not indicted and no major JPMorgan bank executives have faced criminal prosecution.

In December, Holder said the Justice Department plans to bring civil mortgage fraud cases against several financial institutions early in 2014, using the JPMorgan case as a template. Civil not criminal. Today, Holder said: "There are no institutions that are too big to indict," and "There are no individuals who are in such high level positions that they cannot be indicted, criminally investigated." Holder’s timing is delicious.

Jamie Dimon, JPMorgan’s chief executive, just got a big raise. Dimon’s pay increased to $20 million for 2013, up from $11 million the year before. The bank’s board of directors approved the increase even though a steady stream of scandals and a raft of regulatory actions have in recent months cast doubt on Dimon’s leadership at the nation’s largest bank. The big raise for 2013 came in the face of opposition from a vocal minority of board members.

Over the course of the year, the bank agreed to a series of high-cost legal settlements, including the $13 billion claim. Dimon led JPMorgan while it committed what government investigators have identified as over 15 frauds, most of them massive. These frauds represent the greatest financial crime spree the government has ever identified. In January of last year, the Federal Reserve and the Office of the Comptroller of the Currency imposed sanctions on the bank for weak risk and financial controls, as well as deficient safeguards against money laundering and violations of the Bank Secrecy Act, over the 2012 derivatives loss; total legal expenses topped the $20 billion mark.

The bigger the frauds committed by JPMorgan under Dimon’s watch, and the larger the settlements, the greater the value that Dimon brings by way of getting the government to settle cheap, and not tear down the bank and put people in jail. JPMorgan’s board must be really satisfied with Dimon’s ability to negotiate a deal with regulators. The directors don’t bear the cost of Dimon’s bonuses. Dimon negotiations with the government ensure that the shareholders bear all the losses of the obscenity of giving Dimon a raise to reward the crime spree that occurred while he was both the CEO and chairman of the board of JPM.

The regulatory and prosecutorial response to JPM’s crime spree has failed to hold a single senior officer or director personally accountable either civilly or criminally. The officers who control the bank are delighted to use bank funds to negotiate deals in which there are large fines, but the government does not prosecute the officers or seek to claw bank their compensation and seek damages from them. The DOJ treats JPM as “too big to fail.” This means that the DOJ will never require JPM to pay the full cost of its frauds and disgorge the full extent of its fraud proceeds if doing so could even come close to creating a concern that JPM would lack adequate capital. This gives Dimon a crushing negotiating leverage.

Holder has zero prosecutions of the elite bankers whose frauds drove the worst financial crisis since the Great Depression. Holder has zero civil cases, and the banking regulators have zero enforcement actions, that bankrupted an elite bank officer or director whose frauds helped drive the crisis. JPMorgan, Washington Mutual, and Bear Stearn’s boards of directors made the officers who led the frauds wealthy for over a decade through their compensation and bonus deals.

So, I’m not sure what Attorney General Holder was really talking about. There are no criminal indictments; JPMorgan has violated multiple laws with impunity; Jamie Dimon gets a big bonus.

Meawhile, the Financial Stability Board, which coordinates regulation for the Group of 20 leading economies, is reported investigating manipulation in the foreign exchange markets, or Forex, and is working on a reform of interest rate benchmarks after the Libor interbank rate-fixing scandal. Britain's Financial Conduct Authority (FCA) and the US Department of Justice have been investigating allegations that traders at some of the world's biggest banks manipulated the largely unregulated $5 trillion-a-day foreign exchange market. In the foreign exchange probe, groups of senior traders are alleged to have shared market-sensitive information relevant for London fix, which is set at 4 p.m. London time, using actual trades.

Just a reminder that so far, we haven’t fixed anything, and everything, every market is rigged. 

Thursday, January 23, 2014 - They Must Think We’re All Morons

They Must Think We’re All Morons

by Sinclair Noe

DOW – 175 = 16,197
SPX – 16 = 1828
NAS – 24 = 4218
10 YR YLD - .09 = 2.77%
OIL + .47 = 97.20
GOLD + 26.30 = 1264.10
SILV + .22 = 20.11

We have economic reports to cover, some interesting news out of China; lots to talk about today. But what is the top story on most major news outlets? Justin Beiber was arrested in Miami for DUI and drag racing his Lamborghini from strip club to strip club. Seriously. We could spend the whole hour talking about it…, if we were brain dead. That is the biggest story in the country, because they must think we’re all morons.

This has been a very quiet week for economic data but today we got a few economic reports.

Initial jobless claims held steady last week at a nearly 2-month low as 326,000 people filed for first time unemployment benefits.

The Markit Flash US Manufacturing Purchasing Managers' Index (PMI) fell to 53.7 for January, its slowest growth in three months. A reading of 53.7 still indicates growth in manufacturing, and the researchers say we shouldn’t read too much into the report because cold weather has to play into the results. According to the economist from Markit: "After allowing for companies that saw production and sales disrupted by the cold weather, the rate of growth of output and orders remained as strong, if not stronger, than seen late last year.”

In another consequence of the weather, natural gas prices jumped more than 5% during yesterday's session, pushing prices to levels not seen since late 2011. This morning, it's close to cracking $5. The government cut its gas inventory forecasts. Also, gas delivery to consumers in New York and Boston set records yesterday as the most recent snowstorm buried the Northeast. Nat gas is a common way to heat homes, especially in the Northeast, and we’ve had some serious storms this winter.

If you’re looking for ways to trade the move, there are funds and ETFs; among the best known is UNG, which is not to be confused with a trade on the oil sector in general. There is a tendency to chase anything that moves fast. I don’t know where the price of nat gas will go from here; I do know the storms will pass.

The Federal Housing Finance Agency reported home prices ticked up 0.1% in November, and were up 7.6% from the year-earlier period. The National Association of Realtors reports sales of previously owned homes rose in December for the first time in 5 months, and capping the best year since 2006. A total of 5.09 million U.S. previously owned houses were sold in 2013 compared with 4.66 million the prior year.

The index of US leading indicators rose in December. The Conference Board’s gauge of the outlook for the next three to six months climbed 0.1 percent after a revised 1 percent gain the prior month that was larger than previously estimated. The report noted progress in the labor market, rising equity prices, rising home values, continued strength in consumer spending, and rising orders to manufacturers. Five of the 10 indicators in the leading index contributed to the increase.

The biggest economic report today came from China. Activity in China's factory sector contracted in January for the first time in six months. Weighed down by weaker domestic and export demand, the flash Markit/HSBC Purchasing Managers' Index (PM) fell to 49.6 in January from December's final reading of 50.5, dropping below the 50 line which separates expansion of activity from contraction. The reading points to a further slowdown in manufacturing and the entire Chinese economy, which then has implications for the US economy. Chinese leaders have pledged to push reforms to unleash new growth drivers as the world's second-largest economy loses steam, burdened by industrial overcapacity, piles of debt and soaring house prices.

And this has been another area of concern about China. China’s growth model appears to be built on a mix of investments and exports and debt; the dependence on debt has been producing diminishing returns. Lending has in recent years been the driver of growth, but each yuan of new borrowing now produces 1/4 the amount of GDP increase that it did five years ago, and now there are concerns about an imminent default in its shadow banking system, or investments made off balance sheet.

The Chinese cabinet is seeking to increase government oversight of lending by companies that currently face little or no supervision. The shadow system has grown in recent years because the Chinese government has too tightly controlled traditional banking. It keeps the interest rates that conventional banks pay to depositors extremely low and gives out cheap loans to state-owned enterprises and favored companies that might not be able to repay the money.

And now it looks like one of those companies might not be able to repay. The China Credit Trust Company has told investors that it may not make a January 31 repayment on what would amount to the equivalent of about $500 million; that’s a big chunk of money but not a scary number, in itself. The problem is that nay significant defaults could shatter the widespread assumption that off-balance-sheet investments carry an implicit guarantee from state banks and their partner institutions. Regulators have warned that investors must assume the risks from high-yielding investments and not expect protection from losses unless such guarantees are explicit. Local governments have largely ignored these injunctions and have stepped in repeatedly in recent years with bailouts for local firms facing default on corporate bonds and trust loans.

The low rates, of course, have led savers to invest money in speculative real estate projects or dubious investments known as wealth management products offered by banks and finance companies that promise higher rates of return. Much of that money is then lent to private businesses and local governments, which cannot get conventional bank loans because regulated banks are required to give preferences to state-owned companies.

If there is a credit crunch, it would be very different from the Lehman contagion we experienced 5 years ago, and so we probably won’t see any Western style back crashes because the financial system is still an arm of the Chinese government. So, it will likely end in an entirely different way, and we’re not sure what that is.

Next week, the Federal Reserve FOMC meeting will take center stage. It will be Ben Bernanke’s final FOMC meeting. And although we see signs of an improving economy, (or as the Fed said: “cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions.")  We have also seen a wobbly start to the trading year on Wall Street; and this came on the heels of the December FOMC meeting in which the Fed announced the first stage of tapering, curtailing asset purchases by $10 billion per month to just $75 billion per month. There is consensus that the Fed will take the next step in tapering next week; announcing an additional $10 billion a month in asset purchases.

The thinking has been that if things get bad, the Fed will simply ride to the rescue by postponing the taper and resuming or increasing asset purchases. We have to start by looking at what it means by “bad”. Economically speaking, it would be bad if unemployment were to spike; another credit collapse such as we saw in 2008 would be  bad; an economic  meltdown of any sort, domestic or international (think China, at least for today) – that would be bad. How about a 10% correction on Wall Street?

Stock market corrections are common, and we are overdue for some sort of correction, just based on past performance. The Fed’s taper announcement may very well serve as a catalyst or just an excuse for a correction. So, will the Fed jump in to clean up?

Not likely. The Fed has set a new course, and they will most likely have to stay the course, at least for the foreseeable future. There has been a concerted effort to emphasize forward guidance as the primary policy tool. Backtracking now would undermine the Fed's credibility. The Fed might like to talk about the importance of its independence and any reversal of taper would be seen as political. And any backtracking would be a serious blow to the Fed’s economic forecasting abilities and the Fed’s credibility.

And then there is the idea that the Fed’s balance sheet has grown too large, too fast. Increasing asset purchases would be seen as increasing the risks of future imbalances given the surge in stock prices that coincided with prior QE programs. In other words, there is the concern that QE could lead to bubbles, especially QE without an exit date would surely end badly. And a final reason, backtracking on taper and jumping back into the markets might not work this time. Each round of QE has resulted in slightly diminished returns. What if the Fed announced new stimulus and it failed to stimulate?

If the Fed is compelled to go back to the QE well, though, the cyclical sectors would be at heightened risk of underperforming as optimistic expectations get wrung out of stock prices. But this would only happen if things get bad (a subjective term) and we would likely see that coming.

The economic data have remained supportive of the Fed's tapering announcement in December. The December jobs report was weak, but it will be revised. Investor expectations are that the economy is stronger; not really strong but certainly not as weak as it was. So the Fed will likely continue with the taper, slowly and surely. And if the economy falters or something melts down, well they still have some other tools in the tool belt.

  

It’s still earnings reporting season and the big report today came after the close of trade as Microsoft posted net income of $6.5 billion, or 78 cents a share, compared with $6.3 billion, or 76 cents a share, in the year-ago quarter.  Revenue rose 14% to $24.5 billion, partly reflecting the release in November of a new Xbox videogame console and a fresh version of Microsoft’s Surface tablet computer ahead of the holidays. The results topped analysts’ guesses. No word on a replacement for CEO Steve Ballmer, who has announced his retirement.

Treasury prices rallied today. In part it was a safe haven move, with the weak data out of China; maybe some rebalancing or even an old fashioned short squeeze. Mortgage rates fell, decreasing borrowing costs for homebuyers. The average rate for a 30-year fixed mortgage was 4.39 percent this week, down from 4.41 percent and the lowest since November. The average 15-year rate slipped to 3.44 percent from 3.45 percent.

I mentioned earlier that we had a couple of reports on housing today. The Federal Housing Finance Agency reported home prices ticked up 0.1% in November, and were up 7.6% from the year-earlier period. The National Association of Realtors reports sales of previously owned homes rose in December for the first time in 5 months, and capping the best year since 2006.

Another report shows that the housing recovery has reached a level where it is increasingly unaffordable. You guessed it, California topped the list. The salary you have to earn to  be able to buy the median home in San Francisco is just over $125,000 as of November, and the median cost of a home in San Francisco is somewhere between $705,000 and $813,000, depending on what data source you look at; best guess is that home prices in San Francisco are up 24% over the past year. San Francisco tops the list of the most unaffordable cities. Next are San Diego and Los Angeles – the California trifecta – then New York City, where a mere $71,245 in income suffices to buy the median home. Households earning the median income of $51,000, well, forget it.

The reason San Francisco tops  the list is fairly simple, the tech bubble has attracted billions in fresh money, and one reason it has gravitated to San Francisco is past history and also tax incentives handed out to tech companies.

San Francisco may be extreme, but housing bubbles are now re-cropping up across the nation – and so are the very factors that helped inflate the prior housing bubble and then magnified the ferociousness of its implosion.

Helocs, or home equity loans, were up 30.8% in the first nine months of 2013 from prior year and are expected to reach $60 billion for the year, the highest level since 2009 when the market was in collapse mode. But it’s still a far cry from 2006, when such loans hit an all-time crazy record of $430 billion. Using the home as an ATM cranks up consumer spending. If the money is plowed back into the house, such as remodeling a bathroom, it adds some value to the house and lowers the risk of the loan. If it is used to buy gadgets, cars, or vacations, it still cranks up the economy in the US and other countries. But when home prices decline, homeowners and banks get slaughtered.

Also, the housing boom has seen the return of creative financing. Interest only home loans are back and they’re especially popular for jumbo loans. In a number of high-cost counties, including San Francisco, these are loans over $625,500 that banks can’t sell to Fannie Mae and Freddie Mac but have to keep on their balance sheets. Bank of America said that 36% of its fourth-quarter mortgages were jumbo loans, up from 23% in the first quarter. And adjustable rate mortgages, or ARMs made up 22% of all purchase loans in December, up from 11% in December 2012, the highest ratio since July 2008.

The result of higher prices has been slowing sales. In December sales volume was down 17.7% in San Francisco and 12.7% in the Bay Area from a year earlier. In California, volume dropped 12.1% to 34,949 sales, the worst December since 2007 – and 19.7% below the average for all Decembers since 1988.

In Palo Alto, at the center of the techie induced price hikes, home prices are now 40% above the prior bubble peak. But don’t call it a bubble, it’s a housing recovery, at least until it pops.

Friday, June 21, 2013 - Summertime

Summertime

by Sinclair Noe

DOW + 41 = 14,799
SPX + 4 = 1592
NAS – 7 = 3357
10 YR YLD + .09 = 2.51%
OIL – 1.39 = 92.92
GOLD + 20.80 = 1299.60
SILV + .52 = 20.22

There are certain phrases that seem to paint a picture. Today stocks ended slightly higher after two days of sharp declines. The phrase that comes to mind is “dead cat bounce”.

Stocks, and pretty much everything, slumped since Wednesday when Federal Reserve Chairman Ben Bernanke laid out the Fed's plans to scale back on its $85 billion in monthly asset purchases. The S&P broke under its 50-day moving average, contributing to 4.6 percent pullback from its all-time closing high reached on May 21. This retreat represents the largest since an 8.9 percent decline between September and November.

For the week, the Dow fell 1.8 percent, the S&P was down percent 2.1 percent, and the Nasdaq lost 1.9 percent. It was the biggest weekly decline for all three since April and also the fourth week of losses out of the past five.

In the four weeks since Ben Bernanke first mentioned that the Federal Reserve Board might start to taper its program of quantitative easing (QE) later this year, more than $2 trillion was wiped off the value of global stock markets — and probably far more from the value of global bonds. On Wednesday, Bernanke held a press conference where he repeatedly said the Fed would not exiting its bond buying program until the economy improved quite a bit from current levels. The markets heard what the markets heard.

If tapering does start well before the end of the year, this will surely be bad news for financial markets and the world economy. After all, the Fed's easy money policy has been the driving force behind the markets for several years; if the Fed stops handing out free money to the banks, then they would have to reconsider their valuation estimates for a whole host of financial products.

Did the markets over-react, or is it possible the Fed will taper, and manage to do so in a way which does not cause trauma to the markets? I don't know, but we will see in the fullness of time.

Part of the market reaction might be the double whammy hitting the global markets; the second part of that coming from China, which is cracking down on credit. I won't claim to be fully aware of what is going on in China, but the basic story is that China’s credit market has been in a bubble for years, with too much lending and borrowing, similar to what happened in the United States during the financial crisis. All that lending helps grow the economy until, one day, the bubble bursts, and it all comes crashing down, as happened the United States. China’s economic growth has been slowing, making a similar a crisis more likely. Chinese leaders seem to be trying to prevent a disaster by basically popping the bubble, a kind of controlled mini-collapse meant to avoid The Big One.

In a real, uncontrolled credit crisis like the U.S. financial meltdown, credit suddenly freezes up, particularly between banks, meaning that the daily loans banks were relying on to do business are suddenly no longer affordable. Banks with too many unsafe loans suddenly owe more money than they can get their hands on, sometimes leading them to default or even collapse. And that means that it suddenly becomes much tougher for everyone else – companies that want to build new factories, families that went to buy a home – to borrow money. That’s an uncontrolled credit crisis, and a number of China-watchers have been worried that China, in its pursuit of constant breakneck growth, could be headed for one.

China’s central bank, which is likely to tamp down all that unsafe lending and over-borrowing before it leads to a crash, appears to have forced an artificial credit crisis.

The People's Bank of China, (like the China version of the Fed) has already tightened credit, making it difficult for banks to borrow money. Something called the seven-day bond repurchase rate, which indicates “liquidity” or the ease of borrowing money, shot way up to triple what it was two weeks ago. Basically, it started looking like a credit freeze; very similar to when Lehman Brothers imploded.

Then last night, Bloomberg reported the Chinese Central Bank had stepped in and offer more than $8 billion in relief. Then other news sources said there was no relief effort. Who knows?

What's next? Well, the Chinese leaders will either back away from the credit crunch or they'll push forward and try to clean out the financial system. Or maybe the whole thing will just spiral out of control. If they can clean out the excesses from the financial system without to much damage, without uncontrolled financial collapse it would be a good thing; and the reality is that the Chinese government has some experience in controlling market shocks. Still, the process is likely to be a bit painful.

Today marks the start of Summer, or the summer solstice, officially as of 1AM Eastern. The sun is straight above the Tropic of Cancer. It's the longest day of the year, at least in the Northern Hemisphere. It look's like it will be a long summer of partisan gridlock in Washington. They couldn't even pass a Farm Bill. The Farm Bill always gets passed. Liberal or Conservative, we all share something in common; we like to eat. The Farm Bill is supposed to insure the food we eat. But most Democrats voted against it, because it cut the food stamps program, and a quarter of the Republicans voted against it, because they hate government spending. There was all sorts of political intrigue about the ability to get a simple bill through the House; imagine game 7 of the NBA finals, the defenders sit down, the refs lower the basket to 6 feet and Lebron James misses a slam dunk. The politics of this is pathetic, but the reality is that this could mean all kinds of problems in the agricultural sector. (By the way, courtside seats for Game 7 in Miami were going for $30,000 each, and admission to the luxury suites topped $50,000.

The good news for the agricultural sector is that the weather should be better this summer than last summer, but that might be bad news as well.

(Gulf of Mexico Dead Zone)

The near record-breaking Midwestern drought of 2012 shriveled corn crops and toasted pasture land. But it did have one positive side effect. The drought significantly reduced the size of the seasonal Gulf of Mexico dead zone. Less rain led to less fertilizer runoff—the dead zone is fed by a buildup of nitrogen-based fertilizer in the Gulf—which meant that the 2012 summer dead zone measured just 2,889 sq. miles. That’s still a zone the size of the state of Delaware, but it was the fourth-smallest dead zone on record, and less than half the size of the average between 1995 and 2012.

This year will be different. Heavy rainfall in the Midwest this spring has led to flood conditions, with states like Minnesota and Illinois experiencing some of the wettest spring seasons on record. And all that flooding means a lot more nitrogen-based fertilizer running off into the Gulf. According to an annual estimate from National Oceanic and Atmospheric Administration, this year’s dead zone could be as large as 8,561 sq. miles—roughly the size of New Jersey. That would make it the biggest dead zone on record. And even the low end of the estimate would place this year among the top 10 biggest dead zones on record. Barring an unlikely change in the weather, much of the Gulf of Mexico could become an aquatic desert.

The nitrogen nutrients that flow into the Gulf, especially during the rainy spring season, encourages the growth of explosive algal blooms, which feed on the nitrogen. Eventually those algae die and sink to the bottom, and bacteria there get to work decomposing the organic matter. The bacteria consume oxygen in the water as they do, resulting in low-oxygen or oxygen-free regions in the bottom and near-bottom waters.

That’s what a dead zone—water, essentially, without air. Sealife—including the valuable shellfish popular in Gulf fisheries—either flee the area, much as you or I would if someone were to suck all the oxygen out of the room, or die. That’s why the dead zone matters—the larger it is, the greater the populations of fish that might be affected. With commercial fisheries in the Gulf worth $629 million as of 2009—and still recovering from the impact of the 2010 oil spill—the dead zone means business.

The major factor driving the size of the dead zone—beyond changing flooding patterns—is the use and overuse of fertilizers in the corn belt. It takes about 195 pounds of fertilizer to grow an acre of corn; 40% of the corn crop is used to make ethanol, which is blended with gasoline. The idea is that it is a cleaner way to run our cars.

Here's the weekend reading list:

http://www.washingtonpost.com/blogs/wonkblog/wp/2013/06/21/washington-has-missed-the-real-inequality-story/

Washington has missed the real inequality story

http://www.rollingstone.com/politics/news/the-last-mystery-of-the-financial-crisis-20130619

The Last Mystery of the Financial Crisis

http://www.nytimes.com/2013/06/21/opinion/krugman-profits-without-production.html?hp&pagewanted=print

Profits Without Production

http://dealbook.nytimes.com/2013/06/20/senator-criticizes-lack-of-supervision-for-banks-consultants/?ref=business

Senator Criticizes Lack of Supervision for Banks’ Consultants