Friday, February 21, 2014 - Grab Tight and Hope for the Best

Grab Tight and Hope for the Best

by Sinclair Noe

DOW – 29 = 16,103
SPX – 3 = 1836
NAS – 4 = 4263
10 YR YLD -.02 = 2.73%
OIL - .50 = 102.25
GOLD + 3.10 = 1327.10
SILV + .03 = 21.95

Sometimes you just grab tight and hope for the best. There is a deal in the Ukraine. Ukraine's opposition leaders signed an EU-mediated peace deal with President Viktor Yanukovich. Under pressure to quit from mass demonstrations in Kiev, Russian-backed Yanukovich made a series of concessions, including a national unity government and constitutional change to reduce his powers, as well as announcing an early presidential election this year. The Ukrainian parliament then voted to revert to a previous constitution, which essentially stripped Yanukovich of some powers, sacked his interior minister blamed for this week's bloodshed, and amended the criminal code to pave the way to release his arch-rival, jailed opposition leader and former Prime Minister Yulia Tymoshenko.

The deal was mediated by the foreign ministers of Germany, Poland and France, and appears to have been a victory for Europe in its competition with Moscow for influence. The European envoys signed the document as witnesses, but a Russian envoy did not. And just because a deal has been signed it doesn’t mean it will be easy. Protesters remain encamped in Kiev's central Independence Square, where approximately 77 activists had been killed over the past week. There were some celebrations but many of the demonstrators were skeptical that Yanukovich could be trusted.

Ukraine still has problems. The country is deeply divided between Russian sympathizers and the opposition which supports the European Union. The country is broke and facing default. They are dependent on Moscow for energy imports. Putin promised $15 billion in aid after Yanukovich turned his back on a far-reaching economic deal with the EU in November, but now Russia is holding back to see how things play out. The devil is in the details but for this moment in time, they are trying to give peace a chance.

Meanwhile the city of Detroit is looking for a fresh start. You might hear that the city of Detroit officially filed for bankruptcy today; that’s not quite accurate. The state appointed emergency financial manager, Kevin Orr filed a bankruptcy plan with the courts. And that’s just the beginning of the strangeness that is Detroit.

To begin the process of restructuring and exiting Chapter 9 bankruptcy, the city of Detroit filed documents with the court outlining its restructuring plans; who might get what, and an idea of what the city might look like after it pays what it can.

Orr proposed 34% cuts to the pension checks of general city retirees and 10% to police and fire retirees, and they would lose cost of living adjustments, and it’s dependent on the city’s two independently controlled pension boards agreeing to support the plan of adjustment. The city has about 24,000 retirees. The city proposed paying about 20% to 30% of its retiree health care liabilities to a newly created trust fund.

The city proposed paying secured bondholders 100% of what they’re owed, while unsecured general obligation bondholders would receive 20%.The significant haircut for general obligation bonds now declared to be unsecured debt likely will upset participants in the $3.7 trillion municipal bond market, where general obligation bonds have traditionally been considered a safe bet for investors. A deal to end costly interest-rate hedges was not included in the plan, but there should be a plan for that within a few days.

The plan also calls for the city to invest about $1.5 billion over 10 years to improve public protection, restore services and reduce blight, including tearing down abandoned houses.

The judge overseeing the city’s bankruptcy, Steven Rhodes, must approve the restructuring plan before it can be finalized. This is likely to involve a fierce court battle with creditors over several months. Again, the devil is in the details, different parties will be upset; but the basic plan appears to be: fewer debt collectors, fewer murders, and fewer abandoned homes.

How will things work out for the Ukraine or for Detroit? We don’t know. In times of crisis, sometimes you just grab tight and hope you don’t get thrown off the horse. That appears to be the game plan of the Federal Reserve as the economy and financial markets collapsed around them in 2008. Today the Fed released transcripts of the Fed policy makers from 2008, when everything hit the fan. The one thing that becomes quickly apparent from the transcripts is that the Fed was not prepared for the meltdown and they were in no way certain about the best response.

As then-Fed Chairman Ben Bernanke said during an emergency conference call on Jan. 21, 2008: "We were seriously behind the curve in terms of economic growth and the financial situation." And so at that meeting, they cut the Fed Funds discount rate target by three-quarters of a percent. Twelve days earlier they had called another emergency meeting and made no change to interest rates. Nine days later, on January 30, they cut rates another 50 basis points.

Then at their September 16, 2008 meeting the Fed left interest rates unchanged, even though Lehman Brothers had just collapsed and insurance giant AIG was in the grips of a crisis that threatened to bring down the whole financial system. By the end of 2008, the Fed had made eight rate cuts, leaving its benchmark short-term rate on Dec. 16 at a record low near zero. It remains there today.

At the September meeting, many Fed officials were far more worried about inflation risks than about the risk of an economic collapse and depression. The word "inflation" occurs 129 times in the Sept. 16 transcript; the word "recession" was uttered just five times. ("Laughter" is noted in the transcript 22 times.)

Lehman fallout was unclear. The day after Lehman declared bankruptcy, Fed officials still didn't have a handle on what the long-term effect would be on the economy. Dave Stockton said: "I don't think we've seen a significant change in the basic outlook. We're still expecting a very gradual pickup in GDP growth over the next year."

Several Fed officials congratulated themselves on the controversial decision to deny funding for a potential acquisition of bankrupt Lehman Bros. The move, however, significantly worsened the crisis. Former Kansas City Fed chief Thomas Hoenig said: "I think what we did with Lehman was the right thing because we did have a market beginning to play the Treasury and us, and that has some pretty negative consequences as well.” And St. Louis Fed chief James Bullard said: "By denying funding to Lehman suitors, the Fed has begun to reestablish the idea that markets should not expect help at each difficult juncture."

And if they were unsure of the effect of the Lehman collapse, they totally misread the failure of Bear Stearns. In April, just after the collapse of Bear, Bernanke seemed to think the worst had passed, saying: “I think we ought to at least modestly congratulate ourselves that we have made some progress," he said. "Our policy actions, including both rate cuts and the liquidity measures, have seemed to have had some benefit. I think the fear has moderated. The markets have improved somewhat." Actually, it was just the calm before the storm. Then at the September 16 meeting, Bernnake made the mistake of self-congratulation once again, saying: “I think that our policy is looking actually pretty good.”

Janet Yellen, the new Fed Chairperson, seemed to grasp the gravity of the situation more than most of her colleagues. At an Oct. 28-29 Fed meeting, Yellen noted the dire events that had occurred that fall. With a nod to Halloween, she said the Fed had received “witch’s brew of news.” Yellen went on to say: “The downward trajectory of economic data has been hair-raising, with employment, consumer sentiment, spending and orders for capital goods, and homebuilding all contracting.” Market conditions had “taken a ghastly turn for the worse,” she said. “It is becoming abundantly clear that we are in the midst of a serious global meltdown.” Yellen had downgraded her economic outlook and was predicting a recession, with four straight quarters of declining growth. She was right about that, even if no one was sure what to do about it.

Maybe they were just tilting at windmills, as Philly Fed President Charles Plosser suggested, saying: “I don’t think that anything that we do today — cutting the funds rate 50 basis points or whatever — is going to make the next couple of months in terms of the overall economy any less painful.”

They thought they should get more regulatory powers in return for bailing out the banks. Richard Fisher, head of the Federal Reserve Bank of Dallas, said in a March 2008 conference call:  "I am just a little worried about being taken advantage of here. The question is, what do we get in return, and how do we make sure that, since we are not the regulator of these dealers, there is indeed discipline?" Of course it turns out there was no discipline. The big banks are now bigger and riskier than ever.

At times they were overwhelmed. At the September 16 meeting a Fed economist said: "We did receive a great deal of macroeconomic data since ... last Wednesday. We didn't seem to get any of it right, but it all netted out to just about nothing."  And everybody had a good laugh.

Eventually, Bernanke seemed resigned to his limitations. In October of 2008, he was asked about the future direction of rates and he answered: “I feel rather unconfident about predicting the path of rates six months in the future, because I’m not quite sure what is going to happen tomorrow at this point.”

To be fair, even though they made a bunch of mistakes, the global financial system did not collapse. Sometimes you just grab tight and hope for the best. 

Wednesday, February 19, 2014 - Stake your Claim

Stake your Claim

by Sinclair Noe

DOW – 89 = 16,040
SPX – 12 = 1828
NAS – 34 = 4237
10 YR YLD + .02 = 2.73%
OIL + .81 = 102.91
GOLD – 11.40 = 1311.90
SILV - .43 = 21.64

This winter has been brutally cold for much of the country, the worst in 20 years. The harsh weather makes an easy scapegoat for slow economic growth and sickly earnings. Every bad bit of economic data and all ugly earnings reports can be buried under the snow and ice. Many companies and sectors aren’t really affected by the weather; while others were definitely slammed.

This is true of new construction. The Commerce Department reports housing starts dropped 16% to 880,000 in January from 1.05 million in December. For all of 2013, builders began work on 926,700 homes, up the most since 2007’s 1.36 million. The good news is that the weather related downturns will eventually melt away like so much ice on a warm sidewalk.

Another report today showed producer prices increased 0.2% in January, led by gains in goods such as food and pharmaceuticals. This follows a 0.1% increase in the PPI in December. Today’s data mark the debut of the PPI after its first major overhaul since 1978, which more than doubles its reach of the economy by including prices received for goods, services, government purchases, exports, and construction. The revamped PPI encompasses 75% of the economy, up from a third of all production for the old index, which reflected the costs of goods alone.

Since services represent the biggest part of the economy, the gauge will offer a broader look at inflation at the producer level. Goods will account for about 24% of the new PPI gauge; while service, including financial services, food wholesalers and transportation providers, make up 63%; prices of government purchases and exported goods represent 11%; construction is 2%. What this new methodology might do is to smooth out inflation at the wholesale level because goods are inherently more volatile than services. What the report reveals is that we are experiencing disinflation.

So, those were the two economic reports of the morning, and the Dow Industrial average was rolling along with about 50 points in gains, then we saw the minutes of the January Federal Reserve FOMC meeting. Fed officials agreed unanimously to continue to slowly reduce the pace of its asset-purchase program by another $10 billion to $65 billion per month and to pledge to keep rates low until “well past” the point where the unemployment rate fell below a 6.5% threshold. This was the first unanimous statement since 2011. And that’s about where the unanimity ended.

A few Fed hawks thought it might be good to increase short term rates within the next few months; a few Fed doves thought it might be good to slow down the pace of the taper; that brought a response that there should be a “Clear presumption in favor of continuing to reduce the pace of purchases by a total of $10 billion at each policy-making meeting, especially if there is no evidence of a change in the outlook.” The debate on changing the forward guidance, the pledge to the market about keeping rates low, was all over the map. Some want to lower the unemployment rate threshold, while others want a more descriptive or “qualitative” guidance.

And the Fed policy makers described the weak December jobs report as an “anomaly”. Now, remember that the FOMC meeting took place just a few days before the weak January jobs report; so I suppose we could describe that as a double anomaly. If there is a third consecutive weak jobs report for February, then I think we might call it egg on the face. The bottom line is that for now, the taper is on track, rates will remain low for at least a year, we’ll have plenty of forward guidance, and Janet Yellen’s job is something like herding cats.

There are a couple of interesting court cases; one involving Argentina and the other, Detroit.

The country of Argentina has asked the US Supreme Court to review a case that has unsettled the Argentinian markets and currency and might force the country to make payments on billions of dollars of defaulted bonds.

The dispute stems from Argentina’s 2001 default on $95 billion in debt. The country offered to substitute bonds worth 25 cents to 29 cents on the dollar in 2005 and made a similar proposal in 2010. Owners tendered about 92 percent of the outstanding debt. NML Capital, a fund run by billionaire Paul Singer, swooped in and bought about $1.5 billion in bonds for pennies on the dollar, and then they did not accept the swap, opting instead to go through the courts. NML sued to collect the full amount, citing a clause in the bond agreement bars Argentina from treating the restructured securities more favorably than the defaulted bonds.

Argentina challenged a lower court ruling that said the country must pay owners of the repudiated bonds in full before it can make payments on a separate $24 billion in restructured debt. The legal fight has put US courts in the unusual position of shaping another country’s financial future. Argentina says the dispute threatens to force a new default, and lower court rulings have led to credit ratings downgrades. The Argentines further argued that the lower court rulings “effectively reach into Argentina’s borders, coercing it into violating its sovereign debt policies and commandeering billions of dollars of core sovereign assets.”

The appeals court rulings in the case are on hold while the Supreme Court decides whether to get involved. Some decision is expected from the Supremes by around April. Argentina previously said it would never pay the funds, which the country’s leaders have called “vultures.” Its legislature passed a law in 2005 barring payment on the defaulted bonds. Another option under consideration is that the country will offer a new restructuring plan to defaulted bondholders and let investors who own the restructured notes swap them into debt subject to local law.

Meanwhile, Detroit is as broke as Argentina. Lawyers are arguing over how to split the money that’s left. A lawyer for the city says Detroit’s general obligation tax pledge doesn’t give bondholders priority over other creditors in its record $18 billion municipal bankruptcy. Bond insurers have sued Detroit, claiming a proposal by the city’s emergency manager to cut payments to general obligation bondholders is illegal. The insurers say that pledges the city made when the bonds were issued give bondholders certain rights over the taxes.

The dispute may require the judge to weigh in on a long-running debate among legal scholars about whether certain municipal bonds get priority over more traditional unsecured creditors, such as public employees or suppliers. The city’s lawyer argued the city’s pledges to bondholders are no different from those made to all unsecured creditors. Such general promises mean the municipal bonds in dispute are unsecured. Detroit didn’t set aside any property that could be used as collateral for the bonds, or create a special lien on the taxes. The current offer would pay public employee pensions 25 cents on the dollar and GO bond holders 22 cents. The bond insurers present their case in a couple of days.

The city may also try again to resolve a dispute over interest-rate swaps that cost taxpayers about $4 million a month. Detroit may present a new proposal for canceling the swaps in the next three or four days.

While historic winter storms have battered much of the US, California is suffering its worst drought on record. The reservoirs of California are just a fraction of capacity. In the dried-up fields of California's Central Valley, farmers are selling their cattle. Others have to choose which crops get the scarce irrigation water and which will wither.

California is the biggest agricultural state in the US - half the nation's fruit and vegetables are grown here. Farmers are calling for urgent help, people in cities are being told to conserve water and the governor is warning of record drought.

Meanwhile, the southern Imperial Valley, which borders Mexico, draws its water from the Colorado River along the blue liquid lifeline of the All American Canal. Farmers are making hay while the water flows, alfalfa actually; which is used as cattle feed and is being exported to China.  In effect, a hundred billion gallons of water per year is being exported in the form of alfalfa from California. It's a huge amount. It's enough for a year's supply for a million families.

Cheap water rights and America's trade imbalance with China make this not just viable, but profitable. We have more imports than exports so a lot of the steamship lines are looking to take something back. And hay is one of the products which they take back. It's now cheaper to send alfalfa from LA to Beijing than it is to send it from the Imperial Valley to the Central Valley.

Japan, Korea and the United Arab Emirates all buy Californian hay. The price is now so high that many local dairy farmers and cattle ranchers can't afford the cost when the rains fail and their usual supplies are insufficient. Hay trucks are a common sight heading north up the road from the Imperial Valley and despite the high prices, the cattle farmers have to buy what they can. Even with recent rains in northern California there's still a critical shortage of water. There will be many questions about who has claim to what, and this is just the early stages of the drought. Stay tuned. 

Thrusday, January 16, 2014 - The “It Could Be Worse” Victory Lap

The “It Could Be Worse” Victory Lap

by Sinclair Noe

DOW – 64 = 16,417
SPX – 2 = 1845
NAS + 3 = 4218
10 YR YLD - .04 = 2.84%
OIL - .07 = 94.10
GOLD + .70 = 1243.70
SILV - .11 = 20.20

The number of Americans filing new claims for unemployment benefits fell for the second consecutive week last week; down 2,000 to 326,000. This might suggest that the December jobs report, which was a weak 74,000 jobs added, maybe that report was just a temporary slowdown.

In a separate report, the Philadelphia Federal Reserve Bank said its business activity index rose to 9.4 points this month from 6.4 in December. Any reading above zero indicates manufacturing expansion in the region.

In another report, the Labor Department said its Consumer Price Index increased 0.3% after being flat in November. In the 12 months to December, consumer prices accelerated 1.5%. A 3.1% increase in gasoline prices was mostly behind the spike in inflation last month. The increase in gasoline was the largest since June and followed a 1.6% fall in November. Food prices rose 0.1% for a third month. There is no wage inflation. Average hourly earnings adjusted for inflation fell 0.3% in December; and with the weakness in the labor market, there is very little chance of wage growth for quite some time.

The Fed targets 2 percent inflation, although it tracks a gauge that tends to run a bit below CPI. And outgoing Fed Chairman Ben Bernanke says inflation is not a problem, and he cited this morning’s CPI report. As for overinflated assets, Bernanke said the Fed is "extraordinarily sensitive" to that risk after the financial crisis, which began with the bursting of a massive property price bubble, but rather than to try to pop bubbles with the blunt tool of higher interest rates, Bernanke said in the Fed is using supervision, regulation and other microeconomic-type tools to be sure the threat is minimal.

Bernanke claims there is no fear of hyperinflation, and he believes the Fed has the tools to manage inflation and avoid bubbles and keep everything under control. And to hear Bernanke talk, you might not think that the past 5 years have been a big monetary experiment. And maybe they have and will continue to avoid bubbles, but if you believe that, then you also believe the markets are fairly valued right now. So, what would happen if the Fed just stopped QE tomorrow? Imagine a market where the Fed just stopped buying Treasuries and mortgage backed securities. You are likely imagining a market dropping about 20%; maybe more.

Anyway, Bernanke is taking a victory lap as part of his farewell tour, and to some extent he’s probably entitled; the extent being that this whole grand experiment could still end quite badly. But for now things are improving, even if it has been painfully slow improvement; still it could be worse; it could be Europe.

If we compare the economic recovery of the United States since the Great Recession with that of the Eurozone, the differences are striking, and instructive. The US recession officially ran form December 2007 to June 2009, while the Eurozone recession ran from January 2008 to April 2009, and then they dipped back into recession in the third quarter of 2011 and lingered for another couple of years. Now you can argue that the US is still in some form of economic malaise, what with 20 million unemployed, but the technical definition of a recession doesn’t always count things like people out of work. In the Eurozone, unemployment is at near record levels of 12.1%, while in the U.S. it is currently 6.7%. In Greece and Spain, unemployment is over 25%, and youth unemployment is approaching 60%.

How are we to explain these differences? The Federal Reserve lowered short-term interest rates to about zero in 2008 and has kept them there since. The Fed also signaled its intention to keep these interest rates at these levels for a long time. And venturing into uncharted territory, the Fed engaged in three rounds of "quantitative easing," or more than $2 trillion of money creation. Just how much the Fed policy served to stimulate the economy is questionable, but there has been some impact. The stock market and the housing market saw an injection of liquidity, and some people got very, very wealthy, and maybe a little  of that spilled over into the broader economy; maybe. At the least, it helped to avoid the double dip that befell the Eurozone.

In the Eurozone, the response was tightening and austerity, and the IMF has now admitted that austerity has led to even higher levels of debt than before, and reduced GDP growth. Now the question is why the Europeans have been so unfortunate to be subjected to much more brutal economic policy than what we have experienced in the United States. While there are many nuances, there are also some simple but deadly important reasons. Most vital is the accountability, or lack thereof, of the institutions making the decisions. In Europe you have the so-called "troika" -- the European Central Bank (ECB), the European Commission, and (more recently recruited) the IMF. These are much less accountable to Eurozone residents -- especially but not limited to those of the most victimized countries (Spain, Greece, Portugal, Ireland, and Italy) -- than even the relatively unaccountable Federal Reserve and US Congress and executive branch are to Americans.

Some examples: In all 27 countries, the IMF recommended budget tightening, with spending cuts generally favored over tax increases. In 15 countries there were recommendations on health care: 14 were to cut spending. In 22 of the 27 countries there were recommendations to cut pensions. In half the countries, the Fund also gave advice on employment protection; in all of them, the recommendation was to reduce employment protections. Reducing eligibility for disability payments or cutting unemployment compensation, raising the retirement age, and decentralizing collective bargaining were also recommended.

But perhaps even more remarkably, this evidence tells us why the ECB allowed repeated and severe financial crises in the eurozone to take their toll on the eurozone and world economy for nearly three years. Not until July of 2012 did ECB President Mario Draghi utter those famous three words -- "whatever it takes" -- which, backed up a few weeks later by the new "Outright Monetary Transactions" program, put an end to the threat of financial meltdown.

After more than 20 European governments have fallen during the prolonged crisis, the pace of the destructive budget tightening there is finally winding down: from about 1.5 percent of GDP in 2012, to 1.1 percent in 2013, to 0.35 percent in 2014. But who knows how many more years it will take to reach normal levels of employment.

This is not to say that the US recovery has been a shining example, and Bernanke should not take too many bows, but it could have been worse.

It is earnings reporting season. Goldman Sachs’ profit fell 21 percent, as revenue from fixed income trading dropped 11% after adjusting for an accounting charge. Fixed income trading revenue accounted for 48% of Goldman's total revenue back in 2009. In the fourth quarter of 2013, it was 25%.

Profit at Citigroup rose 21%, after adjusting for items, as it cut costs and released dipped into funds set aside for bad loans. Now worries. What could go wrong?

Right before Christmas the Emergency Financial Manager for Detroit negotiated a settlement to end a costly interest rate swap with two investment banks. Ending the swaps with UBS and Bank of America Corp's Merrill Lynch Capital Services for $165 million was a key component of Detroit emergency manager Kevyn Orr's plan to adjust the cash-strapped city's finances through the municipal bankruptcy process.

Detroit currently pays about $50 million a year to the banks in exchange for the swaps, which provided a steady interest rate of about 6% on a $1.4-billion pension funding deal. That equals nearly 5% of the city’s sparse general fund budget.

The $165 million deal represented a 43% discount from a previously negotiated deal for a payment of $285 million to the banks, which the bankruptcy judge said was far too generous to the banks. Today, that same bankruptcy judge said the $165 million is still too high a price to pay.

Bankruptcy Judge Steven Rhodes said the city must stop making poor financial decisions, and it’s his judicial responsibility to ensure it emerges from Chapter 9 bankruptcy as a financially sustainable municipality. 

It represented a major win for Detroit retirees, city residents, the pension funds, several European banks and a bond insurer called Ambac Assurance, which aggressively fought the settlement. Because Rhodes denied the deal, they stand to get more money from the city’s eventual bankruptcy restructuring. It represents a major loss for the investment banks. Before you celebrate, this just sets the stage for a possible legal battle.

Monday, January 06, 2014 - A Cold Forecast

A Cold Forecast

by Sinclair Noe

DOW – 44 = 16,425
SPX – 4 = 1826
NAS – 18 = 4113
10 YR YLD - .03 = 2.96%
OIL - .31 = 93.65
GOLD - .20 = 1238.80
SILV + .02 = 20.27

A few big things this week. Friday we'll see the monthly jobs report. Today we had the confirmation of Janet Yellen, no surprise there; on Wednesday we'll see the minutes of the most recent FOMC meeting which will give us the justification for the taper. The minutes will likely include strong differentiation between taper and tightening, and the Fed is likely to stress the importance of accommodative monetary policy and ultra-low interest rates for the next 18 months or so.

Any bond gains have been curbed as we start the new year; a combination of the Fed slowing its bond purchases, plus corporate supply, plus there is still the safe haven aspect of bonds in the face of a few days of weakness in the equity markets. This Friday's jobs report will prove important as a barometer for yields. More than 2.2 million jobs were probably created in 2013, the most since about 2.5 million eight years earlier. The estimates call for 195,000 net new jobs in December and the unemployment rate to hold at 7.0%. If the economy added more than 200,000 jobs we might expect a more aggressive taper; fewer than 200,000 jobs and the taper might be more sanguine.

Healthcare spending in the US rose 3.7% in 2012 to $2.8 trillion, the fourth year in a row in this range as the slow economic recovery tempered private insurance use, drug prices fell and the government held back payment increases for doctors. For the first time in more than a decade, health care spending grew more slowly than the US economy from 2010 to 2012. It marks the slowest rate of increase in healthcare spending since 1960, even though that $2.8 trillion figure represents 17.2% of the national economy. Expenditures on health care, including everything from hospital procedures to prescription medicines, rose less than 4 percent a year from 2009 through 2012, after growing by an average of more than 7 percent from 2000 through 2008 and by double digits in the previous decade.

Today the Institute for Supply Management said its index on services fell in December, while the Commerce Department said new orders for factory goods rebounded in November following a drop in October. The pace of growth in the services sector slowed for a second straight month in December with business activity expanding at a lower rate and new orders contracting, according to the Institute for Supply Management. ISM’s index fell to 53 points last month from 53.9 in November, dropping to its lowest reading since June 2013 and under expectations for a read of 54.5. A separate report from the Commerce Department showed new orders for factory goods rebounded in November, rising 1.8%, as had been forecast. The department also said orders for durable goods, manufactured products expected to last three years or more, rose 3.4% instead of the 3.5% increase reported last month. Durable goods orders excluding transportation rose 1.2%.

And then, just to keep things interesting, Alcoa kicks off the earnings reporting season. And after the Fed minutes on Wednesday, the Bank of England and the European Central Bank will meet to determine monetary policy on Thursday. It should be a fun week.

Last Friday, Fed Chairman Ben Bernanke gave an upbeat outlook on the economy but he cautioned that the recovery "clearly remains incomplete." That was part of an economic conference in Philadelphia. Bernanke got most of the attention, but one of the more interesting comments came from New York Fed President William Dudley, who said  a lot is still unknown about how the bond buying works. His observation is important because he has long been a supporter of aggressive Fed actions to help the economy. The New York Fed leader has for some time expressed support for continuing the purchases, even as he also voted in favor of the Fed’s decision last month to cut back.

Referring to the Fed’s stimulus program, Mr. Dudley said, “we don’t understand fully how large-scale asset-purchase programs work to ease financial market conditions—is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?” Mr. Dudley also said that when it comes time to unwind the Fed’s easy-money stance, uncertainty is again a major issue facing central bankers. “There could be unintended consequences” about moving to a more normalized state of monetary policy, he said.

I tend to think that such uncertainty runs deeper than it appears at the Fed, which is why policymakers are eager to end asset purchases. The more they buy, the more they risk "unintended consequences" at exit time.

It's a cold week for most of the country. Spot wholesale electricity in Texas  topped $5,000 a megawatt-hour for the first time as cold weather boosted demand and prompted the grid operator to import generation from Mexico and ask users to conserve power until at least tomorrow. Power consumption on the Electric Reliability Council of Texas network, which covers most of the state, averaged 53,369 megawatts for the hour ended at noon, a 6.7 percent increase from the day-ahead forecast of 50,034 megawatts. One megawatt is enough to serve about 500 homes during mild weather and about 200 homes during periods of peak demand.

The forecast is extreme: 32 below zero in Fargo, N.D.; minus 21 in Madison, Wis.; and 15 below zero in Minneapolis, Indianapolis and Chicago. Wind chills, what it feels like outside when high winds are factored into the temperature, could drop into the minus 50s and 60s. That's dangerous cold weather. Frostbite and hypothermia can set in quickly at 15 to 30 below zero. A flu epidemic has now spread across half the country. It hasn't been this cold for almost two decades in many parts of the country.

There have been plenty of problems associated with the weather, not the least of which is air travel. Airlines canceled 4,400 flights on Monday, bringing the total to more than 17,000 over the last week. Today, there is a scheduled flight worth noting, Delta Flight # 2014 from Minneapolis to Atlanta; it marks the last commercial flight for the DC-9. For the past nearly 50 year, the Douglas DC-9 was an aviation workhorse, credited with bringing jet service to most small and medium sized US cities. Delta was the launch customer for the DC-9 back in 1965.

Business bankruptcy filings in the US dropped 24% last year to the lowest level since 2006. The American Bankruptcy Institute reports the total filings by businesses and individuals fell to 1.03 million, the report said, from 1.19 million in 2012.

A trial over how Detroit should end costly financial contracts with two big banks was suspended today after more than a foot of snow fell, paralyzing much of the city and closing the federal courthouse there. Creditors of the city had been scheduled to make their closing arguments against a plan for Detroit to pay $165 million to exit the contracts, known as interest-rate swaps. The creditors say that termination fee improperly favors the two swap counterparties, Bank of America and UBS.

The storm also stopped the trial just as a group of creditors accused the mediator who negotiated the swap-termination deal of misconduct. The creditors filed an objection last week, contending that the mediator had exceeded the limits of his authority when he publicly praised the $165 million deal and said he would recommend that the bankruptcy court approve it.

The creditors, including both financial institutions and labor groups, complain that the swaps were invalid from the time Detroit signed them, in 2005. They say that if Detroit took legal action against the two banks, instead of paying them to end the contracts, the city could obtain a much better deal. If Detroit cannot obtain the new loan, proposed by Barclays Capital, the city has warned that it soon will soon be out of cash and unable to pay its workers.

It was not clear when the trial might resume.

JPMorgan Chase is expected to announce this week that it has reached civil and criminal settlements to the tune of $2 billion for ignoring the signs of the Bernie Madoff Ponzi scheme. Madoff used JPMorgan as his bank, and this is basically a money laundering charge against JPMorgan. All told, after reaching the Madoff settlements with federal prosecutors in Manhattan and regulators in Washington, the bank will have paid some $20 billion to resolve government investigations over the last 12 months, and there might be more settlements in the months ahead. Authorities have opened a bribery investigation into JPMorgan’s hiring practices in China, prompting the bank to turn over internal emails and documents about its “Sons and Daughters” hiring program, which employed the children of the nation’s ruling elite.

The Madoff case, perhaps the largest threat to JPMorgan as it hung over the bank these last five years, produced its own damaging emails. The emails, some of which came to light in a private lawsuit against the bank, suggest that even as questions swirled about the legitimacy of Mr. Madoff’s operation, JPMorgan continued to do business with him. In one internal email sent before Mr. Madoff’s arrest in December 2008, a senior risk manager at JPMorgan reported that another bank executive “just told me that there is a well-known cloud over the head of Madoff and that his returns are speculated to be part of a Ponzi scheme.” No individual executives have been accused of wrongdoing.

JPMorgan’s Madoff settlements will also likely involve a so-called deferred prosecution agreement, a criminal action that would essentially suspend an indictment as long as JPMorgan acknowledged the facts of the government’s case and changed its behavior.  JPMorgan has publicly maintained that “all personnel acted in good faith” in the Madoff matter; they may have to modify that position in light of the deferred prosecution agreement.

Friday, December 27, 2013 - Fooled Again

Fooled Again

by Sinclair Noe

And now we present the curious case of Michael Steinberg. Not familiar? That's understandable; Michael Steinberg is a convicted felon, securities fraud and conspiracy, specifically insider trading. Steinberg is a close personal friend and former trader with Steven A. Cohen. You've likely heard that name. Cohen is the billionaire, stock picker who runs SAC Capital hedge fund; recently fined $1.2 billion by the SEC for insider trading and not maintaining adequate supervision of his employees. Cohen has not been charged as an individual.

Eight SAC employees have been criminally charged; six have pleaded guilty and are cooperating with the government; one faces trial in January; Steinberg just lost his trial, and when the verdict was announced, the fellow fainted. The other guy who faces trial in January fainted when he was arrested. It's a bit funny, a bit pathetic. Steinberg faces a maximum of 85 years but that won't happen. Still, it looks like a potential case against Cohen could gain traction.

The US Attorney's Office in Manhattan has secured 77 insider trading convictions since 2009, without losing a single case. Jurors are capable of understanding insider trading. It's a fairly simple form of cheating. Jurors are also capable of understanding more complex forms of cheating. The markets are rigged by cheaters, in the form of insider trading and other, more complex scams. There are many honest people who earn god livings in the markets, but there are plenty of cheaters. The prosecutors aren't even going after the folks on the other side of the insider trades; someone supplied information on Weight Watchers, Gymboree, Dell, Nvidia, and Intermune (and others). At some point, those people expected something for their information. There is an old saying: if you can't identify the “mark” at a poker table, it's you.

No need to actually sit at the table with big time hedge fund types – you're still the “mark”. Just look at what's happening in Detroit. I knew it was just a matter of time until we started hearing more about how the big banks bet against Detroit; slowly but surely the information is oozing out as the vultures fight over the carrion.

Detroit, of course, has many problems, long standing problems. Back in 2005, Detroit's pensions were underfunded to the tune of $1.44 billion. Then-mayor Kwame Kilpatrick and other city officials set up nonprofit entities and corporations to issue the debt, and bought interest rate swaps as a hedge against rising interest rates (more precisely, they were sold interest rate swaps). Interest rates then dropped to the lowest levels in history; they lost the bet. Detroit owes the holders of the swaps the difference between the interest rates, adding to the pensions' underfunding by as much as $770 million over the next 22 years. Essentially, the politicians and banks gambled with the city's debt, and that bet may have exceeded legal limits on the debt; raising the question of whether the illegal bet is valid. There will probably be lawsuits.

And now that Detroit is in bankruptcy, the unelected emergency manager of Detroit, Kevin Orr, worked out a tentative deal to pay the UBS AG and Bank of America Merrill Lynch Capital Services more than $300 million in “secured debt”. Those banks are considered secured creditors because Detroit put up revenue from three casinos as collateral for the loan; which is now the only stable source of revenue for Detroit. The initial settlement would given the banks about 80 cents on the dollar of what they are owed, compared to 16 cents on the dollar that Orr has offered to retirees for their pensions. The judge told attorneys for Orr’s team to renegotiate the casino money deal because every deal the city has made relating to the swaps “has been made with a gun to its head”.

And so they went back to the table, and they have come up with a new deal, an incrementally better settlement that leaves much of the original structure intact. If the deal is approved by federal bankruptcy Judge Steven Rhodes, Detroit would get out of the swaps deal for about 56 cents on the dollar, get $120 million in cash to bolster city services and free up casino revenues, crucial to the city’s ongoing operations, that were used to secure a previous renegotiation of the swaps deal in 2009. Detroit might be smart to argue that the two major issues with the swaps in the bankruptcy proceeding: whether the swaps are secured debt, and whether the deal was legal in the first place. A favorable ruling for the city on either matter could result in a far better outcome than what has been agreed to.

Over the past five years Detroit has reduced its salary expenses by 30 percent. More than 2,350 public jobs have been cut, accelerating the city’s already notable pace of deterioration. Far from uncontrollable, the cost of health benefits for the city’s public workers and retirees has risen more slowly than the national rate of 4 percent a year. Since 2008, Detroit has reduced its spending by more than $400 million. In the same period, city revenues have fallen by nearly $260 million, with a steep decline after 2011. This decline, rather than its pension obligations, more than accounts for the city’s projected deficit this year of $198 million.

One consequence of these cuts is that public services like transportation, infrastructure maintenance and education are barely functioning. And yet there is one expense that has, so far, been spared: service fees on derivatives that were sold to the city by banks backed by UBS and Bank of America. In fact, these fees are the only significant increase in spending over the past five years. There have been many numbers tossed about in the Detroit bankruptcy, including the claim that the pensions are underfunded by $3.5 billion, but by some calculations, if you strip out the wheeling and dealing, the actual underfunded amount may be closer to $800 million. The public sector pays for the mistakes of the financial sector, and observers are led to believe that the basic promise of retirement is the city’s problem.

This isn't the first time the “swaps” problem has hurt municipalities, we also have examples from Montgomery County, Alabama and San Bernardino, California, and at the core is the question of whether pensions, secured by 20, 30, or 40 years of work are more or less secure than bets by banks. A new report by the Center for Retirement Research at Boston College indicates that costly pension promises are not the major cause of municipalities weak financial conditions. The researchers compared 32 cities that have recently made headlines as they struggle with serious budget problems to a list of 149 other cities that are in relatively good financial shape. "When identifying the source of the problems, fiscal mismanagement leads the list," the study's authors found. "Economic problems, in large part a response to the financial crisis and ensuing recession, come in second." And, "In many cases pension were a contributing factor, but they weren't the driving factor in the fiscal challenges these cities are facing."

Our next story takes us to Switzerland, where 300 Swiss banks are working to meet Department of Justice year-end deadline to put a stop to tax evasion by American clients. Banks with reason to believe they violated tax laws can ask the DOJ to waive prosecution if the banks disclose how they helped Americans hide assets, and the banks will be required to hand over data on undeclared accounts, and pay penalties. If the banks don't apply for waivers and cooperate, then the banks and their customers could face criminal probes.

To gain the non-prosecution deals the banks must pay 20% of the value of accounts not disclosed by August 2008, 30% for accounts opened between August 2008 and February 2009, and 50% for accounts opened afterward. Fourteen Swiss banks are already part of criminal investigations. The crackdown on tax cheats really took off back in 2009, when the US charged UBS, the biggest Swiss bank, with aiding Americans in hiding some $20 billion in assets. UBS admitted it fostered tax evasion; they paid $780 million in fines; they avoided prosecution.

The banks are complaining, whining really, that the penalties are too high. Some Swiss banks may decide to opt-out of the non-prosecution deal, but that comes with a risk. Nearly 40,000 clients told the IRS all about their offshore accounts so that they might avoid prosecution. If it is later learned that some of those clients had accounts with banks that skipped the non-prosecution deal, it would seem like a slam dunk case against the bank. One area that still seems confusing is how to treat multinational corporations with headquarters in the US but offices in Switzerland.

You might think the decision to opt-in to the non-prosecution deal would be simple because the banks aren't really paying a penalty; the money comes from client accounts; it isn't really the banks' money; it is the clients' money. Of course this is not how banksters think. Once the money is in the banks' account, it becomes their money; it is capital they can leverage, and then use to trade.

Just a reminder, we're talking about tax evasion, the same crime that brought down Al Capone. Imagine some petty thief robs the local liquor store and steals a case of beer; he won't get a non-prosecution deal by just handing over a few beers to the cops. Meanwhile, two Swiss banks, Wegelin and Bank Frey, have already gone out of business; and UBS estimates several more will likely close in the coming year. Tax evasion is the business model of the Swiss banks; without it they really can't function. The practice has become institutionalized over time. There is a much older model for taxation: render unto Caesar.

We “celebrated” the Federal Reserve's 100^th anniversary on December 23. Of course, we could probably eliminate taxes if we could just come up with a better central bank. The government, if it and not the Fed was in control of its money supply, could spend as needed to meet its budget, drawing on credit issued by its own central bank (not the Fed); it could do this until price inflation indicated a weakened purchasing power of the currency. Then and only then, could the government need to levy taxes; and the need for taxes would not be to fund the budget but to counteract inflation by contracting the money supply.

In 1977, Congress gave the Fed a dual mandate, not only to maintain the stability of the currency but to promote full employment. The Fed also has another job, as a regulator of the banking system; and as a regulator, it is an abysmal failure; worse than an atheist priest.

There is a discipline in economics known as the “theory of repeated games” and the basic idea is that if you repeatedly cheat at a game, then it increases the likelihood that I will retaliate by trying to cheat you. Of course that is just a theoretical game. In the real world, I might just stop playing your game. When corruption and cheating permeates a society, everything starts to break down, fairness and trust turn to dust and the vacant, crumbling buildings of Detroit.

You have probably invested through Wall Street at some time or another, and yet we know that insiders rig the game; they cheat to fatten their own wallet at your expense. We know that the banks change the laws to make their wagers more “secure” than the pensions of retired cops and firefighters. Even the new deal for Detroit values banks bets at 56 cents on the dollar but pensioners would only get 20 cents on the dollar. Ah, but you might not have a public pension, so you are not concerned. Do you have a private retirement account? A 401k or IRA? The banksters have no more respect for private accounts than public accounts.

Political and economic inequality go hand in hand with a two-tiered justice system, and at the root of the rot are the banksters, cheating the system, lying on a grand scale, and doing it all with impunity. Maybe 2014 could be the year when we won't be fooled again. Best wishes for the New Year.