Tuesday, September 03, 2013 - Welcome to September

Welcome to September

by Sinclair Noe

DOW + 23 = 14,833
SPX + 6 = 1639
NAS + 22 = 3612
10 YR YLD + .10 = 2.85%
OIL + .89 = 108.54
GOLD + 15.70 = 1413.20
SILV + .75 = 24.38

Well, we still haven't started the war, yet. Congressional leaders from both sides of the aisle lined up in support of military intervention. The Senate Foreign Relations Committee opened a hearing and grilled Secretaries Kerry and Hagel. Tomorrow, Kerry and Hagel are scheduled to appear before the House Foreign Affairs Committee. The debate is shifting away from “Did Assad use chemical weapons?” to “What should be done about it?”

Clarity of objectives seems to be a work in progress. Maybe all the talk will eventually consider the possible consequences of a military attack on Syria. Is it really possible to bomb a country and avoid deeper involvement? So far, the politicians are trying to work it out in a logical progression; if A, then B. That's not always how it happens in war. Logic gets thrown out the window.

At this time of crisis, it is worth remembering another time, 30 years ago in October, 1983 when US warships bombarded Lebanon, the country located next to Syria. Within weeks, the US Marine barracks in Beirut was blown up by a massive truck bomb that killed 241 American servicemen: 220 Marines, 18 sailors and three soldiers. The truck driver/suicide bomber was an Iranian national whose truck contained explosives that were the equivalent of 21,000 pounds of TNT. Two minutes later a second suicide bomber drove a truck filled with explosives into the French military compound in Beirut killing 58 French paratroopers. France is the only country standing with the Obama administration on a military strike on Syria, and they might put that support to a vote of parliament.

Mr. Obama has invited the Republican and Democratic leaders of the House and Senate defense, foreign affairs and intelligence committees to the White House this afternoon. Later, he'll fly to Russia for the previously scheduled G-20 economic summit, a forum that will put him across the table from Vladimir Putin of Russia.

August is finally behind us. No more excuses for the market. No more low-volume rallies and corrections. The Dow was red-hot at the beginning of the year. Its components were easily besting the broad market, delivering gains usually reserved for popular growth stocks. However, the summer was far from kind to the Dow. It began to slip in early July relative to the S&P 500. As of right now, the Dow has yet to find its footing. Even today's modest gains were well off session highs.

So, we head into September to the rhythm of the war drums. It promises to be an interesting month. If the major market indices can't catch a meaningful rally now, it is hard to imagine how the indices could sustain a meaningful rally later in the month. September has earned its reputation as the worst month of the year for the broader market, with the S&P down an average of 0.5% over the past 70 years. Not every year is negative; seven of the past ten years have seen positive September returns.

This Friday we get the monthly jobs report. Expectations are for a slight uptick from July's 162,000 headline result with no change to the unemployment rate from the prior reading of 7.4%. Remember good news is bad news for the markets, fearful of losing their spot at the trough of the Fed's easy money. This morning, the ISM report popped up to 55.7 as the manufacturing sector continued to expand for a third straight month; and the yield on the 10-year Treasuries popped to 2.88% In two weeks, the Fed FOMC will meet and consider slowing the flow of easy money, a cutback or taper of QE3. Toss in ongoing speculation about a replacement for Bernanke, and let the fireworks begin.

Congress will officially reconvene next Monday and they will be focused on the Syrian war, but don't forget the battles over taxes and spending, regulations and safety nets, and how to get the economy out of first gear. Which means more gridlock and continual showdowns over budget resolutions and the debt ceiling. They still haven't figured out exactly what is being cut as part of the sequester. Earlier this year, the House and the Senate passed spending bills for the 2014 fiscal year, which begins on Oct. 1, that were about $90 billion apart, but never settled on a final figure. Congress is expected to pass another stopgap bill, known as a continuing resolution, financing the government for a few more months, but it is unclear whether such funding will stay at current levels or shrink. This is actually important because if they fail to come to a deal before October, many parts of the federal government could shut down. Not a complete government shutdown, but death by a thousand cuts.

We're emerging from the depths of the worst downturn since the Great Depression but nothing fundamentally has changed. Corporate profits are up largely because payrolls are down. Cost cutting has limits, and we've started to see those limits in the revenue numbers from second quarter earnings reports. Businesses need customers, and the customers are holding tight to the purse.

While the debate rages over Syria, American workers have been taking to the streets to demand a bit more pay. So as Congress reconvenes and the battles resume, be clear about what's at stake. The only way back to a buoyant economy is through a productive system whose gains are more widely shared. One of the totally unanswered questions about Syrian military intervention is how we're going to pay for it. It's not cheap to park five destroyers in the Mediterranean; it's not cheap to lob a few hundred cruise missiles over the waves; it gets real expensive, real fast if anything goes slightly askew.

Where does the money come from? It won't be coming Detroit or San Bernardino. In July, Detroit filed for bankruptcy. Last week, San Bernardino filed for BK. Two of the biggest municipal bankruptcies in US history.

After kicking the can down the road, with increasing desperation, for many years, the end of the line has been reached. The city is finally admitting that far too many financial promises have been made, and that the majority of these simply cannot be kept. It does not matter whether the promise-holders have a good case for receiving services or needing payments, or even if they have legal protections. If the promises can be broken, they will.

Strange as it may seem, the bankruptcy filings don’t appear to have unnerved the $3.7 trillion municipal bond market. The momentum defies predictions that the muni market would go into a deep freeze following the Motor City’s financial collapse and Detroit Emergency Manager Kevyn Orr’s plan to impose losses on some bondholders. There’s not a lot of evidence to show this has been the death knell for GO [general obligation] bonds.

Everyone thinks it’s just Detroit, but Detroit is not unique. It’s the same in Chicago and New York and San Diego, San Jose, Stockton, and San Bernardino. It’s a lot of major cities in this country. They may not be as extreme as Detroit, but a lot of them face the same problems. Detroit is merely the first of many municipalities to hit the wall, where the realization dawns that far too many promises have been made, and nowhere near all of them can be kept. Different classes of stakeholders are still assuming that their claims will somehow be protected. They are typically thinking of those claims in isolation, without considering the implications for other groups whose rival claims would have to be subordinated. It has been clear for a long time that we would reach this crunch point

Investors in municipal bonds are typically looking for a dependable income, stable bond prices and shelter from taxes. They have generally come to regard these investments as risk-free, even as the obvious problems faced by municipalities have been mounting. The bankruptcy of three cities in California last year seems not to have been interpreted as the warning signs that they were, and so far, relatively speaking, neither does the bankruptcy of Detroit. This complacency is highly unlikely to last, however, as the extent of the inevitable losses in Detroit becomes clear. The clear risk is that bond prices will crash on spiking yield, and that this will precipitate a rush for the exits. A move in this direction has begun, and concern is rising, but as yet it remains a muted response.

Public pensions are also a major stumbling block; supposedly protected by Michigan state law; the law might not protect retirees. What and who will be protected by the law? Under both the Dodd-Frank Act and the 2005 Bankruptcy Act, derivative claims have super-priority over all other claims, secured and unsecured, insured and uninsured. In a major derivatives fiasco, derivative claimants could well grab all the collateral, leaving other claimants, public and private, holding the bag.

Welcome to September. 

Wednesday, July 11, 2012 - Toodaloo San Berdoo

Toodaloo San Berdoo
-by Sinclair Noe




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


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


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




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


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


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


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




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




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


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






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




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




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


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


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


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


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


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


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




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



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




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


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


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


Is there a better way? Maybe. 


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


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


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


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


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


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


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


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