Monday, August 04, 2014 - Giving Up the Ghost

Giving Up the Ghost
by Sinclair Noe

DOW + 75 = 16,569
SPX + 13 = 1938
NAS + 31 = 4383
10 YR YLD - .01 = 2.49%
OIL + .09 = 98.38
GOLD – 6.00 = 1289.20
SILV - .17 = 20.23

Let’s start with economic data; on Friday we had the monthly jobs report: 209,000 jobs and the unemployment rate ticked up to 6.2%. It was a decent jobs report but came in a little under expectations. Still the economy has been adding jobs at a strong clip this year. Early in 2014, the Conference Board’s employment trends index pointed to stronger job creation even though the economy temporarily contracted, and that’s exactly what happened. Hiring accelerated, the economy snapped back in the second quarter, and over the past six months the economy has added jobs at the fastest clip since 2006.

The Employment Trends Index increased in July to a reading of 120.31, up from 119.91; this represents a 6.6% increase from a year ago. The 6 month growth rate in the index is the strongest in over 2 years, and suggests solid job growth is likely to continue in the coming months. Job openings keep hitting post-recession highs. There were 4.64 million job openings in May, near an all-time high; and layoffs are extremely low, even compared to the prerecession period.

While there are some signs of strength in the jobs market, wages have been stagnant. Worker pay was a smaller piece of the US income pie than earlier estimated as some Americans collected significantly more in interest and dividend payments over the past two years.  According to revised data from the Commerce Department, employee compensation, including wages and benefits, was lower for each year from 2011 to 2013 than previously calculated. With the revisions, employee compensation was reduced by $9.5 billion in 2011, $5.1 billion in 2012 and $14.6 billion last year. It accounted for 52% of gross domestic income in the last quarter of 2013, down from a prior estimate of 52.2%.

More rank-and-file workers are participating in the recovery as companies report record profits and boost hiring. Compensation has accelerated this year, rising $134 billion after a $153 billion surge in the first quarter. It marked the biggest back-to-back gains since the six months ended in the first quarter of 2007. That’s because companies are hiring again and more people are returning to the workforce, not necessarily because paychecks are getting fatter. We’ve added millions of people to the payroll since the low point of the economy, but we haven’t added at all to the payouts that workers are receiving. Little has flowed to workers except as an increase in their employment rate.

The latest data on consumer credit is due out Thursday. It’s likely to show non-revolving debt like auto and student debt is continuing to grow rapidly. But credit-card debt has barely budged. Auto loans made up a big part of the growth in second quarter GDP. In the second quarter, motor vehicle and parts spending grew an annual 17.5% rate. Put another way, cars made up 3.7% of all consumer spending, the highest rate since the first quarter of 2008. Growth in subprime auto loans has climbed more than 130% in the past five years.

The New York Times recently reported that many subprime auto lenders are loosening credit standards and focusing on the riskiest borrowers, and then many of the subprime auto loans are bundled into complex bonds and sold as securities by banks to insurance companies, mutual funds and public pension funds, a process that creates ever-greater demand for loans. Subprime loans make up about a third of new car-sales and two-thirds of used cars; with many subprime loans carrying interest rates of 23% or more; the loans were typically at least twice the size of the value of the used cars purchased.

Now maybe you are thinking that there were financial reforms put in place following the downturn; reforms that would prevent subprime lending practices. The Dodd-Frank Act did create the CFPB, the Consumer Financial Protection Board, and you might imagine this would protect consumers from less- than scrupulous lenders. Auto loans were stripped out of the CFPB's jurisdiction by an amendment proposed by Representative John Campbell (R-CA), a former used car dealer. Ripping off poor people has become an art form, and one of the requirements is that the companies engaging in this performance art keep themselves outside regulation as much as possible.

General Motors Financial said today it was served with a subpoena from the Department of Justice directing it to turn over documents related to underwriting criteria on subprime auto loans. The Financial Institutions Reform, Recovery and Enforcement Act, allows the Justice Department to sue over fraud affecting a federally insured financial institution.

A Federal Reserve survey of 75 domestic and 23 foreign banks shows that banks are seeing solid demand for loans, but the banks aren’t making it easy for borrowers. Banks reported stronger demand for prime residential mortgages for the first time since last summer and for home equity lines for the first time since October 2013. Credit standards on prime mortgage loans have eased somewhat, but mortgage standards still remain tighter than in 2005. The July survey also shows that new qualified mortgage rules has reduced approval rates on applications for prime jumbo home-purchase loans and nontraditional mortgages but have not impacted prime mortgages. Banks were somewhat more willing to make consumer-installment loans than they were in the April survey.

New research from the Federal Reserve and Northwestern University finds that expanding unemployment insurance benefits reduces the likelihood of mortgage delinquency. About 5 million foreclosures were completed between 2008 and 2012, but it could have been much worse. The survey says unemployment benefits prevented about 1.4 million foreclosures between 2008 and 2012.  

The researchers discovered there were other side benefits from jobless benefits. Banks who saw a lower default risk expanded credit access. Mortgage investors lost less than they otherwise would have. Local governments took a smaller hit. Also, more owners hanging onto their properties meant that homes stood a better chance of not falling into disrepair, which in turn would have sunk property values in their neighborhoods. And here’s one key finding for housing-policy wonks: Fewer troubled properties cut the government’s costs for expanding jobless benefits by narrowing the number of bad loans that would have been covered by federally controlled mortgage-finance giants Fannie Mae and Freddie Mac. Savings related to Fannie and Freddie decreased net costs for the federal government’s jobless-benefits expansion by about one-fifth.

Today’s bank failure comes from Portugal, and it was a big one. Banco Espirito Santo gave up the ghost; the bank will be shut down, and its healthy businesses transferred to a new bank. Portuguese officials were unable to find private investors to prop up the bank, and so the government will use 4.9 billion euro, or about $6.6 billion of its own funds to bail out the bank, or at least part of it. The bank will be spit in two, with the healthy part going to Novo Bank; the healthy part will include deposits and viable assets; so for now, the depositors and senior bondholders are safe.

Regulators are investigating possible accounting fraud and abuse of privileged information by the Espírito Santo family. Toxic loans, mainly to the Espirito Santo corporate parent and various subsidiaries, will be quarantined in a separate bad bank, which will be owned by shareholders and junior bondholders. Eventually, the new bank, or Novo Bank, will be sold in an attempt to recover the taxpayer loan. It is not clear whether even a sanitized version of Banco Espírito Santo will be worth enough to repay the loan.

Banco Espírito Santo provides something of a preview of what may happen in October when the European Central Bank discloses the results of an exhaustive review of bank holdings in the eurozone. The review is intended to uncover precisely the kind of hidden problems that have undone Banco Espírito Santo.

The central bank review is expected to expose an unknown number of other banks with problem loans or other woes that they have failed to disclose to regulators or shareholders. There has been concern that the central bank’s findings could destabilize the eurozone financial system. The European Union still lacks a comprehensive system for dealing with troubled banks, meaning countries must finance their own bailouts.

There is a new study taking a look at the state of banks in the US, the limits of Dodd-Frank reform, and what should be done with banks that are too big to manage. The study was requested by Democratic Senator Sherrod Brown and Republican Senator David Vitter, and the study finds that some institutions remain too complex and interconnected to be unwound quickly and efficiently if they get into trouble. That means that banks still would be able to force a taxpayer bailout in some form, and the banks are essentially receiving value in that implied guarantee. And the new study had the Government Accounting Office look at the value of that implied bailout. Turns out it was a tough calculation as the value of the implied guarantee varies, skyrocketing with economic stress (such as in 2008) and settling back down in periods of calm. If we were to return to panic mode, the value of the implied taxpayer backing would rocket. In other words, the threat of high-cost taxpayer bailouts remains very much with us.

Thursday, April 25, 2013 - Austerians v. Keynesians

Austerians v. Keynesians

by Sinclair Noe

DOW + 24 = 14,700
SPX + 6 = 1585
NAS + 20 = 3289
10 YR YLD + .01 = 1.71%
OIL + 1.79 = 93.22
GOLD + 36.70 = 1469.20
SILV + 1.24 = 24.50

Five years ago the banking system nearly imploded and almost resulted in a meltdown of the global financial system. Three years ago Congress passed the Dodd-Frank financial reforms, aimed at correcting some of the problems of 2008. Dodd-Frank may have included some good ideas, but you had to wade through 2,000 pages to find anything worthwhile. Much of the legislation has still not been implemented, and on the issue of averting another banking system implosion, it really didn't do much; it basically called on regulators to do a better job of catching problems and nipping them in the bud. We all know that's not going to happen.

And so, the biggest banks have been getting bigger than before the financial crisis and it's widely believed that if a big bank were to fail, they would be bailed out.., again. The government considers these banks to be Systemically Important Financial Institutions, which means they are Too Big to Fail. That implied backing has given firms a green light to engage in risky activities that pose a threat to the financial system.

Yesterday, Senators David Vitter and Sherrod Brown introduced legislation that aims to end the implicit guarantee of a government bailout. Brown and Vitter are calling for big banks with more than $500 billion in assets to have capital equal to 15 percent of their assets. Banks with at least $50 billion would have to set aside 8 percent. Community banks, those below the $50 billion threshold, would be exempt because they typically have large reserves.

There are global capital requirements for big banks; known as the Basel III requirements, but that is a risk-weighted measure; the banks can still count very risky assets, although less-risky assets get a higher ranking.

The legislation presents Wall Street megabanks with a clear choice: either have enough of your own capital to cover your own losses or downsize until you are no longer a risk to taxpayers. The banks are opposed to the idea. Shocking, right? The banks claim that if they have to hold enough capital to cover their losses, that means they would have to cut back on lending. This would probably be a better argument if the banks were actively expanding their lending as opposed to actively expanding their proprietary trading.

This is proposed legislation at this time. And even though it has strong populist support, it probably has a snowballs chance in Blythe, in July. However, it should prove a valuable fundraising tool for the politicians willing to oppose it. Brown and Vitter may have honorable intentions, but this is how Congress really makes its pocket and re-election money.

So, five years down the road; no solutions.

For the past five years there has also been a debate about how to lift the economy out of the hole left by the near financial meltdown. One one side were the Keynesians and on the other side, the austerians. The Keynesians, following the ideas of the British economist John Maynard Keynes, wanted to increase government spending to offset weakness in the private sector. The idea is that this stimulus spending would reduce unemployment, create demand, and prop up economic growth. The austerity crowd wanted to cut spending to reduce deficits and restore confidence. The austerians were following the ideas of economists Kenneth Rogoff and Carmen Reinhart, among others, who claimed that if  governments did not cut spending, countries would soon cross a deadly 90% debt-to-GDP threshold, after which growth would be permanently impaired.

This was more than just an academic debate. Japan embraced austerity and its economy stagnated for two decades. Europe embraced austerity and its economy has been battling rolling waves of recessions, and in some countries, economic depression. The most recent numbers out of the Euro-zone show new highs in unemployment for Greece, Spain, and France. Distrust of the Union is at all time highs. On Monday, José Manuel Barroso, the European commission president said the austerity policies being applied, mainly under pressure from Berlin, had reached the "limits of political and social acceptance" and were "unsustainable" in their current form.

Here in the US, we have seen a mix of austerity and stimulus and the results have been mixed as well. We cut back on government jobs; we had the fiscal cliff; we are now facing the sequester. If you don't like the idea of long delays at the airport, sorry but that's just the beginning. The sequester is throwing around 600,000 people out of work according to the Congressional Budget Office. These are people who have the necessary skills to fill jobs in the economy but who will not be working because people in Washington lack the skills to design policies to keep the economy near full employment. It just makes sense that the government needs to address budget issues and eliminate waste and fraud and unproductive programs. Meanwhile, the Federal Reserve has been pumping money into the financial system, but not into the broader economy. The results have been sluggish growth, unsustainable growth. So, QE doesn't seem to be successful, either.

And then last week we learned that the Rogoff-Reinhart paper was based on bad arithmetic. Once the error was corrected, the "90% debt-to-GDP threshold" instantly disappeared. The discovery of this simple math error eliminated one of the key "facts" upon which the austerity movement was based. So, you might think the debate is over; the Keynesians have defeated the austerians; stimulus beats sequesters. Not so fast.

Excessive debt is still problematic, just that the specific levels of 90% debt to GDP is not a precise level. And stimulus, at least in the form of Quantitative Easing, hasn't been nearly as effective as we would like. So, what's wrong? The biggest problem is that the stimulus has been coming from the Federal Reserve in the form of monetary policy and not from the government in the form of fiscal policy. The Fed has been stimulating the banks by adding more debt to the financial system; this is the equivalent of putting out fire with gasoline.

And, all the money the Fed has been pumping into the banks, has not trickled into the broader economy.  QE does not actually increase the circulating money supply. It merely cleans up the toxic balance sheets of banks. Ben Bernanke is infamous for suggesting that the Fed could crank up the printing press, or to follow the idea of Milton Friedman, deflation could be cured by simply dropping money from helicopters. A real “helicopter drop” that puts money into the pockets of consumers and businesses has not yet been tried. Why not?

It seemed logical enough. If the money supply were insufficient for the needs of trade, the solution was to add money to it. Most of the circulating money supply consists of “bank credit” created by banks when they make loans. When old loans are paid off faster than new loans are taken out (as is happening today), the money supply shrinks. The purpose of QE is to reverse this contraction.

But QE isn't really a matter of the Fed cranking up the printing press; it is actually an asset swap. The Fed exchanges dollars for the banks' toxic assets. It's a way to clean up the banks' balance sheets; it probably keeps the banks from going bankrupt and creating another financial meltdown, but it does nothing for the balance sheets of federal or local government, or most businesses, or consumers.

Quantitative easing as practiced today is not designed to serve the real economy. It is designed to serve bankers who create money as debt and rent it out for a fee, or use it for trading. Bernanke has long claimed that he needs the help of fiscal stimulus to really stimulate the economy. Maybe, but it doesn't really seem the Fed has done it's part to stimulate the broader economy, rather it has decided that the broader economy takes a backseat to resuscitating the zombie banks. And at the same instance that Bernanke calls for fiscal assistance, the Fed proclaims it's independence from the government. Bernanke has proclaimed this independence on several occasions. The unanswered question is that if the Fed doesn't serve the government, then who do they serve?

For the austerian crowd, their debt limits have been debunked, but even worse, their timing sucks. Cutting budgets while simultaneously propping up the balance sheets of the banksters is a double whammy that drains the life blood of economic growth. The QE stimulus doesn't send money to Main Street and the budget cuts take money away from Main Street. It shouldn't surprise you to learn that this combination isn't working. Money has not been circulating. The velocity of money has now slowed to a near standstill; a mere ratio of 1.54, the lowest in more than 60 years.

So, now that the austerian arguments are in shatters, it would seem a good time to revisit stimulus; not stimulus for the big banks, but direct stimulus. And one of the questions that must be asked is what is the definition of public debt? We know there are big differences in household debts. We know that if we accumulate debt for consumer purchases, we can quickly dig a hole. But if we accumulate debt to start a business or to educate our family so we can get a better job, that debt might be worthwhile. In short, there is a difference between debt and investment.

And one lesson we should have learned from the financial crisis is that we can't count on the banks to facilitate investment in the broader economy. We have a choice to support the banks' toxic balance sheets and their gambling addiction or support investment in the local economy. Of course that would require some legislative and executive backbone; so don't hold your breath.