Tuesday, April 29, 2014 - Lowering the Bar

Lowering the Bar
by Sinclair Noe

DOW + 86 = 16,535
SPX + 8 = 1878
NAS + 29 = 4103
10 YR YLD + .02 = 2.69%
OIL - .12 = 100.72
GOLD - .40 = 1296.90
SILV - .13 = 19.54

The S&P/Case-Shiller home price index for February showed prices up 12.9% from February a year ago, that’s down from the 12-month advance of 13.2% reported in January. The index tracks existing home sales in 20 major metropolitan areas, and this economic report tends to lag, plus it is a 3-month moving average of prices; so maybe we could be seeing one of the last reports to reflect bad winter weather.

Home prices fell in 13 of the 20 cities in February compared with the previous month, and it wasn’t just cold weather cities; prices in Las Vegas dipped 0.1% in February from the previous month, the city's first monthly decline in nearly two years; home prices fell 1.6% in Cleveland and 0.7% in Tampa, Florida. Las Vegas still posted the biggest 12-month gain, with an increase of 23.1%.

The Conference Board said its index of consumer attitudes dipped to 82.3 from an upwardly revised 83.9 in March; still, very near a 6-year high.

A new report today from the National Employment Law Project finds that as the economy has inched toward recovery, low-wage jobs have returned far more quickly than middle- or high-income work. The report’s finding shows how the housing sector in particular is a key middle-income employer that has failed to rebound.

Employment among specialty trade contractors, who earn a median wage of $20.03 an hour, is still down 22%. The number of workers who manufacture wood products, with a median pay of $14.94 an hour, is down 27%. Jobs working in rental and leasing services, with a median wage of $14.17 an hour, are down 16.3%. Employment in “credit intermediation and related activities,” which includes mortgage lending, is down 7.1%. Those jobs pay a median wage of $18.51 an hour.

Homebuilders have been slow to pick up the pace of construction, which in turn is squeezing the housing market. Without good job growth among younger and middle class workers who would be first time home buyers, builders are focusing on higher-end projects, which is a smaller market. It’s the old idea that workers need to be paid enough to buy the products they make, otherwise, the market falters, and it becomes harder and harder to break out of the downward cycle.

The Federal Reserve FOMC is meeting today and tomorrow. The outcome is expected to be rather boring; more of the same; reduce the amount of money it is pumping into the economy by another $10 billion per month. The Fed’s purchases of long-term bonds, known as quantitative easing, are widely expected to end in the fourth quarter of this year. The steady phase-out has become routine and predictable. It will only become interesting if the Fed goes off script.

The US treasury reports the biggest debt paydown in 7 years. The drop in net marketable debt will be $78 billion in the April-June period, $38 billion more than the paydown projected three months ago, with an end-of-June cash balance of $130 billion. That trend may be temporary. A faster pace of hiring and soaring corporate profits are lifting tax receipts while spending increases at a slower pace. That’s helping shrink a budget deficit projected this year to be the smallest as a share of the economy since 2007. (Considering what followed, maybe we shouldn’t rush to paydown.)

The majority of S&P 500 companies are reporting better than expected earnings, albeit on lowered expectations; that’s the plan, lower the bar and step right over it.  Easy, right? Not always.

Twitter stumbled today, posting a first quarter loss of $132 million or 23 cents per share, compared to a loss of $27 million or 21 cents per share a year earlier. Revenue more than doubled to $250 million but it wasn’t enough. Shares were hit by 9% in after-hours trade.

EBay posted a loss of $2.3 billion compared to profit of $677 million a year ago. Revenue rose 14%, but shares dropped nearly 4% in after-hours trading.

A number of health-care related companies reported earnings today. Here’s a quick summary. Merck beat estimates by 9 cents; share price was up about 3%. Bristol Meyers Squibb beat earnings estimates but revenue missed expectations; shares down 3%. Cubist Pharmaceuticals posted a 30 cent per share profit, while analysts had expected a loss; shares up 4%. HCA Holdings’ earnings came in one penny short and then they lowered guidance; shares down 4%.

Pfizer has bid $100 billion for AstraZeneca, the biggest and latest in a series of proposed big pharma mergers. Traders and investors love big mergers because it represents a possible liquidity event, mainly for the party being acquired. Earlier this month, Valeant Pharmaceuticals offered to buy Allergan in a deal valued at more than $45 billion, while Novartis sold and exchanged business units with Eli Lilly and GlaxoSmithKline. And Mallinckrodt bought Questcor Pharmaceuticals for $5.6 billion. On Monday, Forest Laboratories, which has been offered $25 billion by Ireland's Actavis PLC, said it would offer up to $1.5 billion for Furiex Pharmaceuticals.

What does this mean for the industry and consumers? Not much good. The Pfizer-AstraZeneca deal is mainly about taxes. Pfizer would become a British company by combining with AstraZeneca, lowering the new company's tax rate dramatically. There's even a euphemism for this kind of move. It's called a tax inversion in the trade. Pfizer's tax rate was about 27% last year. In the UK the corporate tax rate stands at 21% and will fall to 20% in 2015. The tax code provides an incentive for US-based companies to move overseas, often times taking good jobs with them. That also means there might be political opposition to the Pfizer-AstraZeneca deal from Washington.

Yesterday, the Obama administration announced a new round of sanctions to punish Russia, even as it acknowledged that sanctions are unlikely to bring an immediate change in Russian behavior. The new measures froze the assets of 7 Russian individuals and 17 companies associated with them, and prohibited any US dealings with them; all were identified as closely linked to Russian President Vladimir Putin. The administration also announced new restrictions on Russia’s import of US goods deemed to contribute to its military capabilities. The European Union said it would expand its sanctions list to include 15 more individuals.

The Russian stock market moved higher today; call it a relief rally. Putin responded by threatening to reconsider Western participation in energy deals in Russia where several western energy companies have big projects underway or planned. ExxonMobil has a deal with Rosneft to explore and develop shale oil fields in the Artic, with a potential of 9 billion barrels in reserves; that would put the value at as much as $900 billion. The sanctions leave Exxon in business with a group headed by a man who’s not allowed into the US. Drilling was scheduled to start in August; might not happen now.

Meanwhile, a New York based investment firm, Goldentree Asset Management is buying Russian bonds, saying the securities offer value after suffering a 5.4% selloff this year. Russian dollar-denominated corporate bonds are yielding 7.2%, up from 5.8% at the end of last year. Patriotism be damned in the chase for yield.

The Supreme Court has breathed new life into Environmental Protection Agency rules targeting air pollution that drifts across state borders, handing a victory to the Obama administration on one of its major environmental efforts. The agency for years, under two administrations, has struggled to carry out a directive under the federal Clean Air Act to protect downwind states from pollution generated in other states, mostly from coal-fired power plants. The EPA’s rules from 2011 were challenged by a coalition of upwind states and industry, which prevailed in lower courts.

In determining how much individual upwind states should be required to reduce their emission, the EPA’s interpretation of the law allows for several factors to be considered, including what it will cost and how much the state has already done to cut pollution. A lower court ruling disagreed with this approach and said the reductions must be proportional to the state’s share of responsibility for downwind problems. In a 6-2 ruling, the Supremes determined the EPA must have leeway to confront the complex challenge of interstate pollution.

Energy Future Holdings has filed for Chapter 11 bankruptcy protection. Energy Future Holdings owns TXU Energy, which has the largest share of the Texas retail electricity market, and Luminant, the state’s largest power generator; the company also has about $40 to $50 billion in debt; making this one of the biggest corporate bankruptcy cases in US history.

Energy Future’s troubles can be traced back to its bet that natural gas prices would rise, helping it repay the interest and loans it took to acquire TXU Energy in 2007, but a glut of US shale production has instead brought natural gas prices to record lows, hurting the company’s bottom line and its ability to pay its debt. And even while natural gas prices spiked sharply higher last winter as bands of arctic air froze broad swaths of the country, it was simply too little, too late. Recently, it skipped a deadline to pay $109 million in interest.

A crucial part of the restructuring is a $7 billion tax liability hanging over Energy Future’s head. When the company took over TXU in 2007, the new stakeholders were spared having to pay that federal tax bill on the acquisition. However, the terms of the deal stipulated that if the company split up, the massive tax bill would come due.  Stakeholders hope they have reached a restructuring framework that will allow them to shed some of their assets without having to pay that tax, and have asked the IRS to rule on their request.

Friday, April 11, 2014 - Corrupt or Incompetent, Take Your Pick

Corrupt or Incompetent, Take Your Pick

by Sinclair Noe

DOW – 143 = 16,026
SPX – 17 = 1815
NAS – 54 = 3999
10 YR YLD - .01 = 2.62%
OIL - .07 = 103.33
GOLD + .30 = 1319.40
SILV - .07 = 20.06

The S&P 500 closed at its lowest level in two months. The gauge slipped 2.7% this week, the biggest loss since 2012. The Dow Industrial are down 2.4% for the week. The Nasdaq Composite Index dropped 1.3% today, capping its biggest two-day retreat since 2011; and down 3.1% for the week; closing at its lowest level in 4 months. The major US indices are all back in the red year to date. Biotechs fell for the 7th week in a row; the worst run since 1998; and now down 21% from recent highs. About 7.4 billion shares changed hands on US exchanges, 5.8% higher than the three-month average.

We are entering a period that has historically been very poor for stocks. The idea is called “Sell in May” or the worst six months. According to the Ned Davis (NDR) database, had you invested $10,000 in the S&P 500 every May 1st starting in 1950 and sold October 31 of the same year, your initial position would only be worth $10,026. Put another way, by investing only from May through October, a $10,000 stake invested in 1950 would have only made $26.

The Labor Department reports the producer price index, gained 0.5% for March. Excluding the volatile categories of food and energy, core PPI prices rose 0.6% after falling 0.2% in February. The University of Michigan/ Thomson Reuters consumer sentiment rose to a preliminary April reading of 82.6, the highest reading since July, from a final March level of 80.

You’ve probably heard about the Heartbleed bug.  Heartbleed is a flaw in OpenSSL, a piece of code intended to create a secure connection between a server and Web browser; for example, between an online shop and customer. The bug allows an attacker to make the server surrender bits of information out of its memory that should not be accessible. What's more, the exploit leaves no trace. The fear is that the bug may expose credit card numbers, passwords, and more.

By some estimates the Heartbleed bug puts two-thirds of all websites at risk. Millions of smartphones and tablets running Google’s Android operating system have the Heartbleed bug. The government has issued a warning to businesses and banks to be on alert for hackers possibly stealing data.

The Federal Financial Institutions Examination Council, made up of representatives from the Federal Reserve Board of Governors, the Consumer Financial Protection Bureau and other regulators, said: “The vulnerability could allow an attacker to potentially access a server’s private cryptographic keys compromising the security of the server and its users. Attackers could potentially impersonate bank services or users, steal login credentials, access sensitive e-mail, or gain access to internal networks.”

And there’s not a lot you, as a consumer, can do until the websites fix the problem on their end. It may take some time. The Heartbleed bug has been found in the hardware connecting homes and businesses to the Internet. Cisco Systems and Juniper Networks said some of their networking products are susceptible to the encryption bug. Security experts say it might help to change passwords on sites you visit, but fixing the network equipment and software means the companies will rely on customers applying patches as they become available. Cisco said it would tell customers when software patches for its affected products are available.

Now for the scary part.

Bloomberg News reports the National Security Agency has known about the Heartbleed bug for 2 years, and rather than report it, or take steps to close it down, the NSA instead regularly used the encryption flaw to gather intelligence. Putting the Heartbleed bug in its arsenal, the NSA was able to obtain passwords and other basic data that are the building blocks of sophisticated hacking operations. The agency found the Heartbleed glitch shortly after its introduction, according to one of the people familiar with the matter, and it became a basic part of the agency’s toolkit for stealing account passwords and other common tasks.

The revelations have created a clearer picture of the two roles, sometimes contradictory, played by the US’s largest spy agency. The NSA protects the computers of the government and critical industry from cyberattacks, while gathering troves of intelligence attacking the computers of others, including terrorist organizations, nuclear smugglers and other governments.

Questions remain about whether anyone other than the US government might have exploited the flaw before the public disclosure. Sophisticated intelligence agencies in other countries are one possibility. If criminals found the flaw before a fix was published this week, they could have scooped up millions of passwords for online bank accounts, e-commerce sites, and e-mail accounts across the world.

If the reports are true, they would represent a serious breach of the NSA's mission.  There’s no excuse for leaving Americans and businesses vulnerable to breaches on this scale. They should be helping to shore up vulnerabilities, not exploiting them. The NSA has issued a statement denying prior knowledge of the Heartbleed bug; which is not a reassuring denial. This is one of the biggest breaches in the history of the internet, and the NSA, which is supposed to watch this stuff, claims they know nothing. For now, the NSA is sticking to their story that they are incompetent rather than corrupt.

Earnings reporting season is gearing up, with an epic miss from the biggest US bank. JPMorgan Chase said its first-quarter earnings fell 20%, driven by a decline in investment banking and mortgage lending. The bank reported net income of $4.9 billion for the first quarter, after stripping out payments to preferred stockholders. That was down from $6.1 billion in the same period a year earlier. On a per-share basis, the earnings amounted to $1.28, missing estimates of $1.39. Revenue, after stripping out the effect of an accounting charge for credit losses, was $23.8 billion, down 8 percent from $25.8 billion a year earlier. Revenues at the bank's fixed income trading business, part of its investment banking unit, slumped 21% to $3.8 billion. Mortgage originations plunged 68% to $6.7 billion, compared with the same period last year; the bank doesn't expect the trend to change anytime soon.

Wells Fargo posted a profit of $5.9 billion, up 14% from the same period in 2013. Still, the bank’s revenue for the quarter fell to $20.6 billion from $21.3 billion in the same period a year ago.

A federal judge has approved the city of Detroit’s latest attempt to extricate itself from some long-term derivatives contracts that have been costing it tens of millions of dollars a year, holding up a settlement as an example of “the very spirit of negotiation and compromise” that he hoped other creditors would follow. Judge Steven Rhodes of United States Bankruptcy Court ruled that Detroit could proceed with a plan to pay $85 million to UBS and Bank of America to terminate the financial contracts, known as interest-rate swaps, that were used to help finance pensions.

Under the terms of the settlement, the two banks agreed to back Detroit’s overall plan of adjustment, which is critical for the city’s push to resolve its bankruptcy by early fall. Municipal bankruptcy rules say that if one class of impaired creditors votes to approve the city’s plan of debt adjustment, the judge may be able to impose the terms forcibly on everybody else. The judge’s decision gives Detroit leverage for settlements with other creditors.

Earlier this year, Judge Rhodes had rejected a previous attempt to end the swaps that called for Detroit to pay the banks $165 million. He called that proposal “just too much money” and noted that Detroit would have a reasonable chance of success if it sued the banks outright, calling the swaps invalid and refusing to make any termination payments at all. The message was to re-engage in negotiations, and apparently it worked.

Detroit’s emergency manager, Kevyn Orr, and other officials have been calling for creditors to negotiate settlements quickly out of fear that Detroit’s case will become a hopeless quagmire if creditors keep fighting the city’s proposals for resolving their debts. The state law that put Detroit under emergency management is scheduled to expire in September.

Detroit entered into the swap contracts in 2005, when it tapped the municipal bond market for $1.4 billion to put into its workers’ pension funds. Much of the deal was structured with variable-rate debt, and the swaps were intended to work as a hedge, to protect Detroit if interest rates rose. But rates fell, and under those circumstances, the terms of the swaps called for Detroit to make regular payments to UBS and Bank of America. The swaps cost Detroit about $36 million a year.

The 2005 borrowing also required an unusual structure to avoid violating the city’s legal debt limit. In 2009, the debt was downgraded to junk, putting the city out of compliance with the terms of the swaps. So Detroit restructured the swap obligations, offering the two banks the tax revenue that it received from local casinos as a backstop.

When Detroit declared bankruptcy last summer, it estimated the cost of terminating its swaps at about $345 million. Days before filing its bankruptcy petition, Detroit said Bank of America and UBS had given it a break, so that it would have to pay only about $250 million to cancel the contracts. But other creditors, facing bigger relative losses, complained that the two banks were still getting way too much. They argued, among other things, that the interest-rate swaps were invalid from the beginning because the use of casino taxes for financial hedges is not allowed under state law. So, Detroit either got off cheap at $85 billion or the banks just stole $85 billion.

Friday, July 19, 2013 - Lights Out on Paris of the Midwest

Lights Out on Paris of the Midwest

by Sinclair Noe

DOW – 4 = 15,543
SPX + 2 = 1692
NAS – 23 = 3587
10 YR YLD - .04 = 2.49%
OIL + .43 = 108.47
GOLD + 13.70 = 1297.70
SILV + .15 = 19.63

So, the big story today has to be Detroit. This isn't a story that moved the stock indices but it did rattle the $3.7 trillion municipal bond market. Selling picked up in the afternoon. Yields on longer-dated triple-A maturities ranging from 2037 to 2043 rose by 9 to 11 basis points. The rise was the steepest since June 24 after the US Federal Reserve rattled markets with talk about scaling back its bond buying program.

Detroit has filed for Chapter 11 bankruptcy reorganization. That's not a full fledged liquidation, which would be Chapter 7, so Detroit can continue to operate during reorganization, and they would then look to reduce debts by paying back a portion of what it owes. Right now, it looks like Detroit owes about $18 billion.

But this is not an easy deal, nothing about it has been easy; and the latest twist is that Circuit Judge Rosemarie Aquilina in Ingham County has said that the bankruptcy filing violates the Michigan Constitution and state law and must be withdrawn. In response, the state attorney general says he will appeal and seek emergency consideration from the Michigan Court of Appeals; and he has asked for a stay pending appeal.

Lawyers representing pensioners and two city pension funds got an emergency hearing Thursday with Aquilina, and she said she planned to issue an order to block the bankruptcy filing. But the lawyers for Michigan governor Rick Snyder asked for a 5 minute delay, and the Emergency Financial Manager, Kevin Orr had his attorneys file the Detroit bankruptcy petition in Detroit, in a different court, 5 minutes before the hearing began.

Aquilina said the Michigan Constitution prohibits actions that will lessen the pension benefits of public employees, including those in the City of Detroit. And Judge Aquilina says Snyder and Orr violated the constitution by going ahead with the bankruptcy filing because they know reductions in those benefits will result.

Assistant Attorney General Brian Devlin, representing the governor and other state defendants, said: “We can't speculate what the bankruptcy court might order," said

Aquilina replied: "It's a certainty, sir. That's why you filed for bankruptcy."

So pensions will be a huge part of the process moving forward, and there are some battle lines being drawn, but the battle lines have been forming for some time.

Kevyn Orr serves as the city's emergency manager, under a 2011 law some commentators have labeled "financial martial law." Once Gov. Rick Snyder (R) signed the law and appointed Orr, Detroit's city contracts and public properties were subject to Orr's sole discretion. Orr began selling off large chunks of public property, even attempting to sell off the city's art collection until the state Attorney General blocked him.

The appointment of Orr was controversial. As Emergency Financial Manager he basically runs the city, not the mayor, Dave Bing, who has been very quiet. And the citizens of Detroit do not have representation in their own city. This is a strange twist on democracy, and there have been voter challenges; overturned in emergency session; and there are lawsuits, lots of lawsuits. And there will be many more.

When he arrived on the job in late March, Orr took control of a city with an estimated $17 billion in long-term debts and a $327 million annual budget deficit. On July 12, the city announced it would stop making payments on about $2.5 billion in unsecured loans and asked some of its creditors — bond issuers, unions and pensioners — to forfeit as much as 90% of what the city owed them in order to avoid bankruptcy.

A primary reason anyone files for bankruptcy is to avoid lawsuits from creditors unwilling to take a large haircut. Detroit is no different. But those representing tens of thousands of city employees and retirees said they still intended to fight the case, particularly for the thousands of retirees who depend on city pensions. And whatever happens in Detroit will be closely followed. If you end up with precedent that allows the restructuring of retirement benefits in bankruptcy court, other cities might try the same tactic.

While a court can’t order a city to sell its assets, the city can sell off the ones it chooses. But many of those assets, like police cars or school buses, are vital to the functions of a city. Others, as Orr found out in May, when he reportedly contemplated selling the Detroit Institute of Art’s collection, are considered sacrosanct by the public.

Another challenge of a Chapter 9 bankruptcy is that it is difficult to get out of contracts negotiated under a collective-bargaining agreement. Detroit will have to prove to the court that dramatically renegotiating is necessary for the survival of the city. According to figures released by Orr’s office, more than 40% of Detroit’s revenues were spent on so-called required payments such as pension checks, bond liabilities, health care benefits and other dues, which are estimated to grow to 65% of the city’s spending in the next four years.

Detroit’s filing may be historic, but it is not unprecedented. Dozens of cities and counties have filed for bankruptcy over the years. The largest city to file for BK before Detroit was Stockton California in June 2012; with about $500 million in debt. Vallejo California filed for Chapter 9 because it couldn't pay its pension obligations. And Jefferson County Alabama, which includes Birmingham, filed in November 2011, after being bamboozled by Wall Street financiers.

Actually, JPMorgan Chase paid $75 million in cash and forfeit $647 in fees to clean up bribery charges involving a politician who green-lighted a series of deadly swap deals to finance a sewer system upgrade which ended up costing triple when the swaps turned bad; the $1.4 billion dollar sewer bond deal ended up becoming $3.9 billion in debt, and threatened to leave Birmingham high and dry.

There is a pattern of Wall Street siphoning off funds from municipalities, going back to the notorious Abacus deal executed by Goldman Sachs against Greece; to JPMorgan's conviction last year in Europe, along with several other banks, for fraudulent sales of derivatives to the city of Milan, Italy. A total of $120 was seized from Chase and three other banks in that case.

While Detroit certainly takes much of the blame for its debts, much of the borrowing the city engaged in under corrupt, jailed former Mayor Kwame Kilpatrick was ill-advised, it's a safe bet the city also got swindled by Wall Street, at least in part.

Numerous factors over many years have brought Detroit to this point, including a shrunken tax base but still a huge, 140-square-mile city to maintain; overwhelming health care and pension costs; repeated efforts to manage mounting debts with still more borrowing; annual deficits in the city’s operating budget since 2008; and city services crippled by aged computer systems, poor record-keeping, worse collection practices, and widespread dysfunction.

Detroit's population has has shrunk from 1.8 million in its heyday in 1950 to 700,000 today. Its tax base has collapsed. It's infrastructure is in shambles. Call 911 in Detroit and wait an hour for police to show up for an emergency. And by some reports, 40 percent of its street lights don't work. Detroit was once called the Paris of the Midwest – and now, it's lights out.

Bankruptcy would take months or possibly years and is itself expected to be costly and complex, and divisive. And then what? It’s not enough to say, let’s reduce debt. At the end of the day, you need a real recovery plan. Otherwise you’re just going to repeat the whole thing over again.

So, what can be done? The downward spiral began decades ago when deindustrialization led to depopulation, crime and declining public revenues. Corruption and mismanagement may have exacerbated the problem, but they weren't the root cause. The gravest mistake we can make today is to believe that Detroit is an anomaly. It isn't. The economic threats that brought down Detroit are present in other great American cities.

The idea that deindustrialization in America is nothing to worry about has been conventional wisdom for several decades. For a long time we have been under the impression that we can manage the finances and outsource the manufacturing; we can handle the design and outsource the production. But that's not how it works. Manufacturing and innovation feeds off the work of our friends and neighbors. The best designs come from people who actually, physically manufacture something. It may look good on paper, but can you really get a wrench in there and if you do, will your arm be in a position to actually turn it? And if you need a part, can you get it from the shop down the street or will you get it from a catalogue and have it shipped from China?

Our tax dollars fund research that helps create amazing products -- that are made overseas and sold back to us. We should insist that federally supported R&D is channeled into the design, engineering, and productions of goods in America.  We should encourage small scale manufacturers to localize manufacturing and reduce imports and establish a new generation of makers and innovators.  Financial deregulation in the late 1990s made the financial sector the master of manufacturing. That, along with the creation of CDOs, swaps, and other get-rich-quick "financial innovations," was a huge mistake. Ensure that our small- and mid-sized manufacturers have access to affordable, patient capital. Circulate money into smaller manufacturers and out of the financial market casinos. Restore the balance of power between the industrial park and Wall Street.

p.s. - here's the link to the Josh Rosner analysis of JPMorgan-Out of Control

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.

Wednesday, June 27, 2012 - To Your Health; Spanish Junk; Barclays Bad; Falcone Flunks; Bhopal Veggie Garden; Goodnight Stockton

To Your Health; Spanish Junk; Barclays Bad; Falcone Flunks; Bhopal Veggie Garden; Goodnight Stockton 
– by Sinclair Noe


DOW + 92 = 12,627
SPX + 11 = 1331
NAS + 21 = 2875
10 YR YLD -.01 = 1.62%
OIL +.27 = 80.48
GOLD + 1.60 = 1575.20
SILV - .17 = 27.04
PLAT – 18.00 = 1415.00


According to the Centers for  Medicare and Medicaid Services, health spending accounts for about 18% of the GDP of the United States. So, tomorrow's ruling by the Supreme Court on President Obama's health care plan is pretty important, but so far the economists can't seem to figure out the implications. This is not to say I have any advance info on the Supreme Court decision. 


They might say the Act is fine as it is, they might say they will eliminate the mandate but leave the rest unchanged, they might throw out the whole thing.  If they vote against Obamacare it will be seen as a highly partisan act. What better way to show the Court’s impartiality than to affirm the constitutionality of legislation that may be unpopular? That might be a stretch; I think I'll stick with the idea that we'll have to wait till tomorrow.


The only safe bet is that there will be unintended consequences. For example, what if the Supremes strike down the mandate portion but leave the rest intact? The Obama administration put a mandate in the Affordable Care Act because the law requires insurers to charge the same premium regardless of health status. Without a mandate, it would make sense for the healthy to drop their insurance until they got sick and needed it. But if only the unhealthy bought insurance, premiums could rise sharply to cover insurance companies’ higher costs. At the extreme, this could blow up the insurance market altogether. 




The National Association of Realtors Pending reports home sales climbed 5.9% in May, with an index reaching 101.1. The index was 13.3% above May 2011 levels. Earlier this week, the Commerce Department reported sales of new homes at two-year highs. Also, S&P/Case-Shiller reported that home prices climbed in April. Also today, the Commerce Department reported durable-goods orders rose a seasonally adjusted 1.1% last month.




Spain is poised for a downgrade to junk by Moody’s Investors Service. Moody's cut  28 Spanish banks yesterday including a two-step cut for Banco Santander and a three-level reduction for BBVA, a week after it lowered Spain’s rating to Baa3, on the cusp of junk. Spain remains on review for another cut by Moody’s after they requested a $125 billion international bailout for its banks and on speculation losses from its real estate industry will worsen. A one-notch move to Ba1 will likely see all the country’s banking system in junk territory, with the possible exception of Santander. Spain’s short-term borrowing costs nearly tripled at auction, underlining the country’s precarious finances as it struggles against depression and juggles with a debt crisis among its newly downgraded banks.


So, it's not just the Spanish banks that are begging for a bailout, it is looking like the nation will also be looking for a bailout. To put it another way; Greece has collapsed; the contagion has spread. Spain is on the edge of collapse. Italy is next.


Oh yeah, French bonds look shaky, and Germany was downgraded yesterday. 


No worries, the Euro-big wigs will have another emergency summit in Brussels starting tomorrow. Maybe it was always a choice between orderly, or disorderly breakup. The idea of European countries working together in harmony sounds good; the idea of European countries bailing out Euro-banks is just stupid. The death certificate for the EU will likely read: “Cause of death: procrastination”. The European Union is crumbling. Have a waffle. 


Federal Reserve Bank of Chicago President Charles Evans said the U.S. central bank didn’t provide enough stimulus last week and called for new easing including more asset purchases to spur economic growth. Evans said: “We should be doing more accommodation than what was adopted under the Twist.” While the move “has small effects,” Evans said, “its larger effect is that it indicates the Fed is continuing to think more accommodation is important and worthwhile.”


The FOMC expanded Operation Twist, its maturity- extension program, by $267 billion through the end of the year. Chairman Ben S. Bernanke said at a press conference the Fed is prepared to do more. Evans said: “Right off the bat, I’d be willing to do more on the basis of the current data”. He doesn’t vote on policy this year.




Last week Microsoft introduced a new tablet computer, called Surface, it has a kickstand and a cover that folds out to serve as a keyboard. Very clever. It will be available for sale in a couple of months. Today, Google revealed its own tablet and it is priced at a sharp discount compared to Apple's iPad. The new tablet will run on the latest version of Google's operating system Android 4.1, called Jelly Bean. The Nexus 7 will sell for $199 and will be available in mid-July. The line between software and hardware has now been breached in the face of total domination by Apple.  


British bank Barclays says it will pay around $452 million in penalties to US and UK regulators to settle a probe into attempted manipulation and false reporting relating to two global benchmark interest rates that form the basis for hundreds of trillions of dollars of transactions. Libor, or the London Interbank Offered Rate, and Euribor, or the Euro Interbank Offered Rate, are benchmark reference rates that indicate the interest rate that banks charge when lending to each other. Almost all other rates are at least partially based upon the Libor or Euribor as a baseline. The CFTC said that Barclays traders and employees attempted to manipulate and made false reports concerning Libor and Euribor in order to benefit their derivatives trading positions. This misconduct took place on many occasions and sometimes on a daily basis over a period of four years, starting in 2005. What does it take for these people to end up in jail? 


Apparently the trick is to have the backing of a major bank, the individual traders  are easy prey for the regulators, but the traders for the big banks have “Get Out of Jail Free” cards. Phillip Falcone, the founder of hedge fund Harbinger Capital Partners LLC, was sued by the Securities and Exchange Commission. The SEC said in its lawsuit that Falcone misappropriated client assets, favored selected investors and manipulated bond prices. 


Robert Khuzami, the SEC’s enforcement director, said in a statement: “Today’s charges read like the final exam in a graduate course in how to operate a hedge fund unlawfully. Clients and market participants alike were victimized as Falcone unscrupulously used fund assets to pay his personal taxes, manipulated the market for certain bonds, favored some clients at the expense of others and violated trading rules intended to prohibit manipulative short sales.”


The SEC is seeking disgorgement of ill-gotten gains, unspecified financial penalties and a bar prohibiting Falcone, 49, from serving as an officer or director of any public company.




The SEC action is the second blow in less than two months for Falcone, who built a $26 billion hedge fund by 2008 with a successful bet against subprime mortgages. LightSquared Inc., Harbinger Capital’s biggest investment, filed for bankruptcy in May.


Falcone in 2009 took out a $113 million loan from his Special Situations fund to pay personal taxes. The loan was disclosed in the fund’s annual financial statement the following March. At the time he borrowed the money, clients were barred from pulling money from the fund. Falcone subsequently repaid the loan with interest. That same year, with client capital locked up, Harbinger allowed Goldman Sachs Group, which at the end of 2008 had $1 billion invested in two Harbinger funds, to redeem some money from the firm.


Dow Chemical's ’s Union Carbide won dismissal of a lawsuit alleging polluted soil and water produced by its former chemical plant in Bhopal, India, injured area residents, one of at least two pending cases tied to the installation known for the 1984 disaster that killed thousands.


U.S. District Judge John Keenan in Manhattan yesterday ruled Union Carbide and its former chairman, Warren Anderson, weren’t liable for environmental remediation or pollution-related claims made by residents near the plant, which had been owned and operated by a former Union Carbide unit in India. Sure, a chemical spill that killed thousands of people, no need for further cleanup. I'm sure everything is nice and clean. I'm sure that Judge would want his children planting a nice little vegetable garden in the shadows of the Bhopal chemical factory.


Exxon Mobil Chief Executive Officer Rex Tillerson says supplying electricity to the “billions of people living in abject poverty” is a more important goal than curbing greenhouse-gas emissions. Tillerson says electricity will do more to improve the quality of life for people who still cook food by burning animal dung than trying to prevent climate change, which will be “manageable.” And even if global warming destroys the planet, maybe ExxonMobil can get the same judge that ruled in favor of Union Carbide. 


Stockton is broke. They will file for bankruptcy. Talks with bondholders and unions failed. Stockton California will now become the biggest US city to seek court protection from creditors. The City of  Stockton released a statement yesterday after its council voted 6-1 to adopt a spending plan for operating under bankruptcy protection. The statement says: “The city is fiscally insolvent and must seek Chapter 9 bankruptcy protection. In addition to the bankruptcy petition, the city will file a motion with the courts to share information from the confidential mediation.”


In the past three years, Stockton was slammed by the collapse of the housing market and city officials dealt with $90 million in deficits through a series of drastic cuts. They eliminated one-fourth of the city's police officers, one-third of the fire staff, and 40 percent of all other employees. They also cut wages and medical benefits. To plug next year's anticipated $26 million budget shortfall, they couldn't find more cuts, and so they turned to the courts to avoid chaos. The budget for the fiscal year beginning July 1 calls for defaulting on $10.2 million in debt payments and cutting $11.2 million in employee pay and benefits under union contracts that could be voided by the bankruptcy court. Stockton’s bankruptcy might resemble the 2008 case of another California city, Vallejo, which exited court protection last year. It is expected that Stockton City workers who have retired will see a sit to health care benefits, possibly a cut to zero. Bondholders and current employees will probably also have to take less. 


The Stockton bankruptcy is not expected to create a sell-off in the $3.7 trillion dollar muni-bond market. The BK was anticipated. The average cumulative default rate in the past four decades was 0.13 percent for municipal bonds versus 11.2 percent for corporate debt. The overall default rates in municipal bonds are extremely low and Stockton is a small participant in the $3.7 trillion market.


A taxable Stockton pension bond sold in 2007 and due September 2037 traded June 25 as high as 80.68 cents on the dollar, down from when it traded as high as 102.03 cents on the dollar on Feb. 15. 


Bankruptcy would allow the city to break contracts with creditors without the threat of lawsuits, though it won’t assure the city’s recovery. Chapter 9 BK does not wipe out debts but merely allows for restructuring. In February, the city began a process during which it is required by state law to review its finances with help from a “neutral observer” who is picked in cooperation with creditors. That review is similar to a mediation process in which creditors have a right to participate. Stockton was the first city to test a new state mediation law, Assembly Bill 506, which is less than six months old. The results have been called tedious, at best; policy analysts issued a report on the use of the new law, titled “Death by a Thousand Meetings”.


According to a June 5th fiscal report, the city has cut services so much the past two years that “public safety is at a crisis level”. Unemployment, at 15.4 percent in April, was almost double the national average; Stockton ranked third in murders last year among large California cities, behind Los Angeles and Oakland; One in every 195 homes in Stockton’s metropolitan area received a foreclosure filing in May, the fifth-highest rate in the nation.


When the economy crashed and the construction bubble burst, Stockton was battered by foreclosures and lost income from property taxes and other fees. Multi-year labor contracts for city workers carrying escalating costs and generous retirement plans added to the burden. In addition, expensive city investments - a promenade, sports arena and hotel - failed to produce an economic boon. There is a state investigation into whether Stockton's financial devastation was entirely due to shortsighted optimism or if there was corruption. The state mediation law requires assigning blame. It will make interesting reading, and I'll lay dimes to donuts, the assignment of blame will be misplaced.