Tuesday, April 15, 2014 - Yellen in the Lions' Den

Yellen in the Lions' Den
by Sinclair Noe

DOW + 89 = 16,262
SPX + 12 = 1842
NAS + 11 = 4034
10 YR YLD - .01 = 2.62%
OIL - .22 = 103.83
GOLD – 24.20 = 1303.40
SILV - .41 = 19.66

Stocks were all over the place today. We started with triple digit gains for the Dow Industrials, dipped to triple digit losses, then back into positive territory for the close with the major indices closing just below their morning highs. This kind of volatility does not engender confidence; it does warrant caution.

The utilities sector gained 1.3% and finished ahead of the other groups, extending its YTD gain to 11.8%; the biotech ETF added 1%, while the broader healthcare sector advanced 1.1%.Tech stocks have been beaten up quite a bit over the past couple of weeks. The Nasdaq 100 Tech Index (NDXT) is down 7% since April 1st. The Nasdaq Composite has exhibited weakness, but not to the point of meeting the definition of a correction; it would take a slide to 3,922 to mark a 10% fall from the March 5 closing high at 4,357; a 10% pullback from the March 6 intraday high of 4,371 would be achieved at 3,934.

The Labor Department’s Consumer Price Index, or CPI, increased 0.2% in March after posting a 0.1% increase in February. Excluding volatile food and energy prices, core prices ticked up 0.2%.Prices rose 1.5% for the 12 months ending in March. That is up from February’s year-over-year reading of 1.1%. Core prices moved up 1.7% over the 12 months, up from 1.6% in February.

A major factor in both headline and core CPI in March was a 0.3% increase in shelter costs. On an annual basis, housing costs were up 2.7%, the fastest pace in six years. The indexes for medical care, used cars and airline fares also increased in March. Apparel prices rose for the first time this year. Household furnishings and recreation prices dipped in the month. Real or inflation-adjusted hourly wages, meanwhile, fell 0.3% in March to $10.31. Real wages have risen 0.5% over the past 12 months. So, we’re not seeing wage-push inflation.

The big difference has been housing; shelter costs account for a full third of the basket of goods and services tracked in the consumer price index. In the past year, consumer prices excluding shelter have risen just 1%, an indication that inflation pressures are subdued outside of housing.

The old rule of thumb was that rents and utilities combined should not take up more than 30% of household income. A new study by Zillow finds 90 cities where the median rent, not including utilities, was more than 30 percent of the median gross income. A study by Harvard finds that nationally, half of all renters are now spending more than 30% of their income on housing, up from 38% of renters in 2000. Part of the reason for the squeeze on renters is simple demand; between 2007 and 2013 the United States added, on net, about 6.2 million tenants, compared with 208,000 homeowners.

For many middle and lower income people, high rents choke spending on other goods and services, impeding the economic recovery. Low-income families that spend more than half their income on housing spend about a third less on food, 50% less on clothing, and 80% less on medical care compared with low-income families with affordable rents.

Federal Reserve Chairwoman Janet Yellen is scheduled to go to the lion’s den tomorrow, making a speech before the Economic Club in New York. Today, Yellen took the show on the road, speaking to a banking conference in Atlanta, she said current rules on how much capital banks must hold to protect against losses don't address all threats. She said the Fed's staff is considering what further measures might be needed, and such measures would likely apply to only the largest and most complex banks. Yellen said the Fed would review the likely effects of imposing stricter rules on banks. That probably plays better in Atlanta than Manhattan.

At some point Yellen must press the case of the Fed as regulator and in control of the banks rather than vice versa. Now, any threat or hint of threat at tighter control is only likely to result in the big banks moving risky behavior into less regulated areas of the financial system. These areas are often called the shadow banking system.

One area of concern for Yellen and her Fed colleagues is the short-term debt markets. So, Yellen would like to see the banks hold more capital; the idea being that it would make them less susceptible to a run. Now, when you hear that the Fed Chair is concerned about a bank run, this is not the old fashioned bank run, with customers lined up at the door of Bedford Savings and Loan and Jimmy Stewart trying to persuade his neighbors that their long-term loans will provide sufficient liquidity to short-term needs.

The problem goes to an area of regulation overlooked, or perhaps neglected by Congress and the various regulators; specifically derivatives; and after the collapse in 2008 what the regulators did was to concentrate the risk of the derivatives among four major Wall Street banks; the big banks just got bigger.

If you’ve ever stood in a teller’s line at the bank, you may have noticed the FDIC sticker, which reads, “Backed by the full faith and credit of the United States Government.” Effectively, that means, if the assessments the FDIC charges the banks to meet the needs of the Deposit Insurance Fund run short, the taxpayer must prop up the fund to make insured depositors whole. On top of that promise, the National Depositor Preference statute came into being in the US in 1993, making all deposit liabilities at insured depository banks preferred over the claims of other creditors.

The serious wrinkle in the plan is that if one of the four largest banks in terms of derivative exposure was put into receivership by the FDIC, its derivative counterparties have the legal right to assert a super-priority claim on the liquid assets of the bank, jumping in front of depositors. Typically, the counterparties start grabbing their collateral before the public is even aware of the problem.

The Deposit Insurance Fund probably has about $40 billion in assets. With the Dodd-Frank prohibition against further taxpayer bailouts of banks, where would the FDIC turn to stem a run on one of the largest banks?

Under the Federal Deposit Insurance Act, the FDIC, acting as a conservator or receiver for an insured depository institution, has the right to “disaffirm or repudiate any contract or lease.” But here again, Wall Street has the FDIC between a rock and a hard place. Let’s say there was a reenactment of 2008 and Citigroup was sliding toward insolvency. If the FDIC repudiated Citigroup’s derivative contracts, it would set off a panic and contagion at the other three largest banks holding trillions in derivatives, creating an even larger financial tab for the Deposit Insurance Fund to meet. Banks taking deposits of public funds are required to pledge collateral against any funds exceeding the deposit insurance limit of $250,000. But derivative claims are also secured with collateral, and they have super-priority over all other claimants, including other secured creditors. The money is gone before you get to the teller’s window.

But before you lose any sleep over the prospects of another, potentially far worse global financial meltdown, take solace that the economy is recovering. There are a few more jobs, and consumers are spending, and the housing market is improving, and the Fed has been pumping money into the economy to foster this growth of credit. Right?

Well, one of the lessons we’ve learned in the recovery is that there is a difference between credit growth and economic growth. And absent real and sustainable economic growth a gap eventually forms as credit growth expands. The more one spends on a place of shelter the less one has to spend on other things, and overall demand is reduced. Bank lending finances the purchase of existing assets, particularly with reference to real estate. Such existing asset finance does not directly stimulate investment or consumption, but it drives up asset prices, and that leads lenders and borrowers to believe that even more credit is both safe and desirable. The expansion is like a rubber band that can only stretch so far.

So, it seems the greatest danger to the current economy are the very mechanisms that are still used to “fix” the last financial crisis: money-printing and asset-purchases by major central banks around the world that unleashed a global flood of liquidity for over five years. Most of this massively huge pile of cash has landed in the laps of banks, institutional investors, hedge funds, private equity firms, and other speculators has not been used to boost lending to the private, and thus has not contributed to the recovery of the real economy. Instead, it has been poured into financial assets and has artificially goosed their valuations.

This money sloshing through the system and the persistence of zero-interest-rate policies have driven desperate investors ever further out into “all risky asset classes,” including emerging assets, junk-rated corporate credit, Eurozone peripheral debt, and equities. That buying pressure has inflated their valuations even further. And in the emerging markets, it led to an appreciation of exchange rates.

And when the rubber band breaks, there will be a derivatives bet on it. When the derivatives default, the counterparties, operating in an unregulated shadow banking world of their own design, do not have sufficient capital to pay off the derivatives bet, and so the first thing they’ll do is raid the bank vaults, and when that dries up, the short-term credit markets freeze, because none of the counterparties have faith that the other party has any more in capital reserves than they have.

Thursday, April 10, 2014 - Mr. Toad’s Wild Ride

Mr. Toad’s Wild Ride
by Sinclair Noe

DOW – 266 = 16,170
SPX – 39 = 1833 (-2.1%)
NAS – 129 = 4054 (- 3.1%)
10 YR YLD - .06 = 2.62%
OIL - .20 = 103.40
GOLD + 5.80 = 1319.10
SILV + .19 = 20.13

If you want to know why the stock market is up one day and down the next, and not just little moves but triple digit swings – I don’t know. If anybody says they know, they probably don’t. Maybe it’s the Fed, maybe it is earnings reporting season, maybe it’s a strong economy or a weak economy, or maybe the markets are just trying to imitate Mr. Toad’s Wild Ride. The one thing we know is that stock prices fluctuate, and over time a pattern or trend develops; right now things are wobbly.

In economic news, the Labor Department said that the number of people applying for unemployment benefits dropped to 300,000, the lowest level in nearly seven years.

The Treasury Department says the federal budget deficit for the first half of the 2014 fiscal year totaled $413 billion, down $187 billion from where it stood at this point last year, as tax revenue surged and spending sank.  In March, the Treasury collected $216 billion in taxes, up 16% from a year ago, helping reduce the deficit for March to $37 billion from $107 billion last year. 

Meanwhile, spending sank by 14%, or $40 billion; military spending has been cut, federal government jobs have been cut, and Fannie Mae and Freddie Mac are no longer a drain but rather a contributor to the Federal coffers. Tax receipts have been increasing as the stock market improved (not necessarily today but remember last year was strong). Also, the economy has been better, not great but better. 

The budget gap last month was the smallest deficit recorded for the month of March since 2000. Over all, the deficit is expected to equal 4.1% of gross domestic product in 2014, down from nearly 10% in 2009, during the depths of the recession. It is the fastest four-year reduction in deficits since the demobilization after World War II.

California is sinking. Scientists estimate that the Central Valley accounts for about 20% of the groundwater that is pumped in the nation. It's the lifeblood of the flourishing agriculture industry, producing crops from almonds to plums, nectarines and cotton. And the water to irrigate is pumped from aquifers that are not being replenished by rainfall.

The US Geological Survey published a study that found that 1,200 square miles of the Central Valley were sinking half-an-inch per year, but the rate is not consistent everywhere. The town of El Nido, just south of Merced sank almost a foot a year between 2008 and 2010. A foot a year is not sustainable. You can’t really mitigate against a foot a year.

Farmers are digging deeper wells, and as the water is pumped out of clay aquifers, the earth above falls to fill the void, and the clay compresses. It’s called subsidence. The land sinks and the compressed clay cannot hold as much water as it once did. Once subsidence happens there is no way to undo it.

About 30% of California’s water supply comes from underground supplies, more during droughts, and about 80% of state residents rely to some degree on groundwater. Some towns, cities and farming operations depend entirely on it. And it has been a problem for a long time. Three generations ago, so much groundwater was pumped from aquifers that half the valley sank like a giant pie crust, sagging 28 feet near Mendota and inflicting damage to irrigation canals, pipelines, bridges, roads and other infrastructure.

The sinking only stopped because of 2 massive government funded irrigation projects, the federal Central Valley project and the California State Water project, which flooded the region with water from distant mountains and relieved pressure on the natural underground water supply. Now, the drought and climate change have opened up a new era of groundwater pumping. The result is the ground is sinking and the land subsidence is perhaps the worst ever seen in California.

This causes multiple problems for infrastructure. Dams and irrigation canals rely on gravity to move water, but when the ground sinks, the water doesn’t always flow as expected.  Flood safety is another concern; flood control channels might not perform as expected as levees sink. Bridges sag; well casings fail; and then there is the issue of the state’s multi-billion dollar high-speed rail line plotted to run through an area that is sinking by about a foot a year.

While the San Joaquin Valley faces the worst problems of land subsidence, other regions of California are dealing with similar problems on a smaller scale. The USGS has been studying sinking ground in the Coachella Valley for years in conjunction with the local water district. In a 2007 USGS study, researchers determined that the ground had subsided up to 4 inches in parts of La Quinta, with smaller effects in parts of Palm Desert and Indian Wells, during a year-and-a-half period from 2003 to 2005.In the Coachella Valley, the ground has sunk in some places where groundwater levels have fallen. Uneven settling has cracked the foundations of houses and fractured walls, swimming pools and roads.

After years of drought, water tables are dropping fast. Well-drilling costs are soaring. The biggest problem is the gradual, irreversible compaction of the earth that occurs when aquifers are pumped to historic lows. It doesn’t make the aquifer unusable. It just reduces the amount of water that can be stored in it, now and in the future.

The Basel Committee on Banking Supervision released its final ruling on just how much derivatives traders have to hold in reserve to pay off on defaults. International regulators are trying to safeguard trades and bring more openness to a $700 trillion market, known for its secrecy.

Swaps are what investors use to help guard against risk (at least theoretically). They’re bought by pension plans and retirement funds to protect against fluctuations in interest rates, meaning they affect most people who own annuities. They’re used by the US government to limit exposure in the mortgage market and cut home-loan costs. Investors can also hedge an investment in a company by buying a swap that will pay them if a borrower stops paying its debts. They’re called swaps because investors and banks exchange, or swap, payments over time based on how interest rates move or how the creditworthiness of companies changes.

Think of it as a form of insurance, with a few major exceptions; swaps do not require an insurable interest. For example, you can buy life insurance for your spouse and your spouse can buy life insurance on you because you have an insurable interest in each other. Your doctor can’t buy a life insurance policy on your life because your doctor does not have an insurable interest. And when you think about it that is a good way to approach insurance. Otherwise, your doctor might buy an insurance policy on your life and then bet against you; which is essentially what many people did with swaps in the financial crisis; they bought insurance on mortgage debts betting mortgages would default.

More frequently, swaps dealers sold swaps to people or entities who didn’t need the swaps or didn’t understand the swaps; for example the city of Detroit or the nation of Greece; they bet interest rates would go one way, and then they took on more debt than was prudent and when rates turned, they lost everything. Swaps made bankers billions of dollars before helping to blow up the global economy in 2008.

The other significant difference between swaps and insurance is that insurance companies must have reserves to pay claims. Swaps dealers, not so much; and so when defaults happen, the swaps contracts have a nasty history of not covering the risks they are supposed to cover. In other words, they never paid their claims.

After the crash, regulators set to work to make them less dangerous, through changes that in the process would make them less profitable. Where swaps had been one-on-one deals before, now they would be backstopped by third parties in clearinghouses that ensure everyone can pay, with the aim of avoiding emergency bailouts and panic. And the new Basel Rules now applies a minimum 20% risk weighting to money deposited at clearinghouses, which are third parties that guarantee the transactions. Note that is not a 20% in actual reserves, just a 20% risk weighting on money deposited at clearinghouses; big difference.

Today’s edition of “Banks Behaving Badly” features a hedge fund, SAC Capital Advisors, run by Steven A. Cohen. A judge has accepted a guilty plea from the hedge fund firm as part of a $1.2 billion criminal settlement for insider trading. In total, SAC Capital has agreed to pay $1.8 billion to resolve criminal and civil probes into insider trading. The Department of Justice said that payout is the largest insider trading settlement in history. The judge said: "These crimes clearly were motivated by greed, and these breaches of the public trust require serious penalties."

Now here is the peculiar part; if these breaches of the public trust require serious penalties why would they not include prison time? The answer is that you can avoid prison if you can pay enough money. SAC Capital has lots of money. Manhattan U.S. Attorney Preet Bharara said: "Today marks the day of reckoning for a fund that was riddled with criminal conduct." Not exactly. Today marks the day SAC Capital writes a check and continues on; that does not constitute a day of reckoning.

Tuesday, March 26, 2013 - Miles to Go

Miles to Go

by Sinclair Noe

DOW + 111 = 14,559
SPX + 12 = 1563
NAS + 17 = 3252

10 YR YLD - .01 = 1.91
OIL + 1.40 = 96.21
GOLD – 5.90 = 1600.50
SILV - .09 = 28.86

The Dow Industrial hit a record hit close today, taking out the March 14 closing high. The S&P 500 came within a couple of points of the high close; it is having a hard time breaking through the ceiling; you just have to content yourself with the idea that the index has more than doubled from the lows of March 2009.

The Chicago Board Options Exchange Volatility Index, which measures the cost of using options as insurance against declines, fell 7.1 percent to 12.77. The gauge has tumbled 29 percent for the year. It is a reflection of complacency.

We have many things to cover today.

Home prices were up in January and the year over year improvement in prices was the fastest in 6 years. The S&P Case Shiller Index of existing home sales was up 0.1% in January, and the year over year gains were 8.1%. On a year-over-year basis, all 20 cities measured by the Case-Shiller index improved, led by a 23.2% surge in Phoenix, with New York bringing up the rear with a 0.6% advance.

Sales of new U.S. homes fell 4.6% in February to mark the biggest drop in two years, though poor weather likely played a big role. Sales slowed to an annual rate of 411,000, down from a revised 431,000.

The consumer confidence index dropped to 59.7 in March, down from 68.0 in February. Most of the drop came from a decline in the expectations index, which slumped to 60.9 from 72.4, though the present situation index also fell, to 57.9 from 61.4. Consumer fears about the sequester are believed to have hurt the confidence numbers. We have nothing to fear but fear itself. It still holds true.

Orders for long-lasting goods surged in February largely because of gains in the volatile aircraft and defense segments, but demand was mixed for other manufacturers. Durable-goods orders climbed 5.7% last month to a seasonally adjusted $232.1 billion after a revised 3.8% drop in January. Orders outside of transportation fell 0.5% to mark the first decline in six months.

There has been a great deal of attention focused on the Dow Industrial Average back to new record highs; less attention on the Dow Transportation Average. The Transports include railroad companies. Shale-energy production exceeds pipeline capacity, and this will continue to be the case for many years ahead. Eventually, new pipelines will be built, but it takes time, and the production of shale oil is just getting started, and it's unlikely that the new pipelines will be enough. Railroad systems are already in place. Energy companies have invested over $1 billion dollars in new rail terminals near the shale operations. They have also put 20,000 new tank cars in service, which is an investment in the billions of dollars

There had been plans to reopen the banks in Cyprus today. Not gonna happen. Maybe Thursday. And when the banks open, there will be capital controls in place, meaning there will be restrictions on withdrawals. Larger depositors could see 40% confiscations. And that is just to raise the money for Cyprus to earn the dubious right to a bailout; the terms of which will likely drive the economy into a depression. Yes, there are protests in the streets of Nicosia.

A state-appointed emergency manager has taken control of the Detroit city government and started a drastic restructuring of its finances and operations. The first order of business was to extend an olive branch to the city government. The manager, Kevin Orr made clear that he alone would be responsible for decisions on how to stem the city’s mounting cash shortfall and reduce an estimated $14 billion in long-term liabilities.

“The statute spells out some pretty clear powers,” he said, referring to the state emergency-manager law that allows him to sell city assets, renegotiate labor contracts and possibly recommend a bankruptcy filing.

There were protests in Detroit, just a few dozen.

Another day, another mind-blowing fact about the staggering difference between the haves and the have-nots. Incomes for the bottom 90 percent of Americans only grew by $59 on average between 1966 and 2011 (when you adjust those incomes for inflation), according to an analysis by Pulitzer Prize-winning journalist David Cay Johnston for Tax Analysts. During the same period, the average income for the top 10 percent of Americans rose by $116,071.

The Federal Reserve has cited Citigroup for failure to comply with federal law requiring banks to establish protections against money-laundering. They did not impose a fine. The Fed's action follows up on a similar order issued against Citigroup last year by two other bank regulators, the Office of the Comptroller of the Currency and the FDIC, which cited it for "deficiencies" in its compliance with the Bank Secrecy Act. The Fed said that Citigroup lacked effective systems of governance with respect to its Bank Secrecy Act and anti-money-laundering compliance programs. Citigroup has 60 days to submit a plan explaining steps the bank has taken to boost its compliance efforts. Some day, some day.

As it did before the financial crisis, Wall Street is bankrolling academics to bolster its case against regulation. Back then, the research gave warm tongue-baths to the virtues of derivatives. This time, the beneficiary is high-speed trading.

A highly publicized research paper from Columbia University claiming that high-frequency trading benefits society and shouldn't be regulated too much was paid for by -- surprise -- a high-speed trading firm.

Unlike most academic papers, this one, by Columbia Business School economics professor, was announced to the world last week and turned into an op-ed headlined "The Reality Of High Frequency Trading."

The argument is that high-speed trading bolsters that magical market stuff known as "liquidity," pushing stock prices higher and making companies richer and more willing to spend money, making us all wealthier. None of that has actually happened yet, of course, with markets and the economy flat since the advent of high-speed trading a decade or so ago. Never mind all that, though: Regulate high-speed trading too much and the liquidity could go away; so says the new research paid for by high speed traders. And bad things happen when the liquidity goes away.

A derivative is a financial product derived from another financial product” (for example, a futures contract tied to a stock index) — in practice, the term applies to a whole world of financial products that are written on a one-off basis between two entities called “counterparties,” as opposed to products that are traded on a broad, well-regulated market. Futures contracts are gambling — I can bet on the Dow to go down or up, for example — but trading in futures contracts is regulated gambling, in which winners are protected from losers, and in many cases, losers protected from themselves.

Not so, derivatives, in the usual meaning of the word. Derivatives in that sense are contracts between parties who want to trade risks, but they aren’t market-traded. They aren’t standardized. And counterparties aren’t vetted by any controlling institution.

It is now estimated that derivatives market has been growing. One of the biggest risks to the world’s financial health is the $1.2 quadrillion derivatives market. It’s complex, it’s unregulated, and it ought to be of concern to world leaders that its notional value is 20 times the size of the world economy. But traders rule the roost — and as much as risk managers and regulators might want to limit that risk, they lack the power or knowledge to do so. A quadrillion is a big number: 1,000 times a trillion.

That refers to the notional value. For example, if I bet on a basketball game, say $24 on the Lakers and $26 on the Clippers, I don't really have $50 of risk, just $2 dollars at risk, or $2 notional value. But the derivatives market is so big that the notional value is now $12 trillion, give or take; a much smaller number, but almost the size of the US GDP, and about 20% of the world economy.

Those numbers about the size of the derivatives markets are just guesses, because the market is unregulated, zero controls. Nobody knows the true size or the true dangers.

Wednesday, January 30, 2013 - GDP Shrinks, Fed Stands Pat

GDP Shrinks, Fed Stands Pat

by Sinclair Noe

DOW – 44 = 13,910
SPX – 5 = 1501
NAS – 11 = 3142
10 YR YLD + .02 = 2.01
OIL + .46 = 98.03
GOLD + 12.50 = 1677.40
SILV + .64 = 32.12

GDP shrank in the fourth quarter, and we had that report on the same day as the Fed wraps up an FOMC meeting. So, I've been reading a bunch o' blogs and articles about how the Fed has been printing money, expanding its balance sheet to more than $3 trillion, failing to generate economic growth, failing to generate jobs, diluting the dollar, and generally condemning the American economy to the inevitable tortures of hyper-inflation. The internets are offering up the full spectrum of opinions: from the idea that the GDP Shows Federal Reserve Just Screwing the Average American to the apologetic Five Reasons the GDP Report is Misleading (hint: the economy will bounce back in a heartbeat, by golly gosh) to Fed Stays the Course: Is Its Monetary Policy Wrong?

Let's start with the GDP report. The economy shrank from October through December for the first time since the recession officially ended, hurt by the biggest cut in defense spending in 40 years, fewer exports and sluggish growth in company stockpiles. The Commerce Department said the economy contracted at an annual rate of 0.1 percent in the fourth quarter. That’s a sharp slowdown from the 3.1 percent growth rate in the July-September quarter, and well below expectations of 1% growth.

The weakness may be because of one-time factors. Government spending cuts and slower inventory growth subtracted a total of 2.6 percentage points from growth; and don't forget Hurricane Sandy, which cut into GDP. The slower growth in stockpiles comes after a big jump in the third quarter. Companies frequently cut back on inventories if they anticipate a slowdown in sales. Slower inventory growth means factories likely produced less. Those categories offset faster growth in consumer spending, business investment and housing; the economy’s core drivers of growth.

Let's look at some numbers. Residential investment jumped 15.3 percent, a sign that the housing sector continues to recover, for one. Similarly, investment in equipment and software by businesses rose 12.4 percent, an indicator that companies are still spending.  The 22.2 percent drop in military spending, the sharpest quarterly drop in more than four decades, along with the drop in inventories and exports overwhelmed more positive indicators in the private sector.

Subpar growth has held back hiring. The economy has created about 150,000 jobs a month, on average, for the past two years. That’s barely enough to reduce the unemployment rate, which has been 7.8 percent for the past two months. We'll see the January jobs report on Friday.

The economy may stay weak at the start of the year because an increase in Social Security taxes is cutting into take-home pay. Tax hikes combined with cuts in government spending is an easy formula for negative growth. Another positive aspect of the report: For all of 2012, the economy expanded 2.2 percent, better than 2011′s growth of 1.8 percent.

Bottom line is that the GDP report was lousy. Which leads to the inevitable question, what went wrong? If the Federal Reserve policy of printing money to get us back into growth was working, trillions should have bought us the biggest expansion in history. Instead it bought us negative growth and 8% unemployment. At what point does the Federal Reserve admit they are wrong? Which probably isn't the right question, but let's look at it anyway.

The Fed wrapped up their FOMC meeting, and they did not admit the error of their ways. The Fed attributed the pause in growth to the impact of Hurricane Sandy and other “transitory factors,” and it said that there were some signs of increased strength in areas including consumer spending and housing.

The Fed affirmed the stimulus program it announced in December, saying that it would hold short-term interest rates near zero at least until the unemployment rate fell below 6.5 percent and expand its holdings of Treasury securities and mortgage-backed securities by $85 billion each month. Keep in mind, QE 4 – To Infinity and Beyond – is a fairly fresh program. The Fed says: “The committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline.”

Still, you have to admit that $85 billion a month starts to add up; 40 billion here; 45 billion there; after a while you're talking about real money. And still no signs of the demon inflation nor economic growth. What does this really tell us? More than likely, the problems with the economy and with the financial sector were and are far worse than the attempted cures. The cesspool of toxic assets still being purged from banks' balance sheets was much bigger than anyone has been willing to admit. The banks have been unwinding their derivatives positions but not eliminating them, and those derivatives were massive; probably somewhere north of $700 trillion dollars, which is a really big number.

To put it into perspective, we should note that the gross domestic product of the entire world stands at around just 60 trillion dollars.  The US residential real estate market is worth 23 trillion dollars.  The total value of all the US stock markets is a mere 16 trillion dollars.  The value of the entire world’s stock markets is about 50 trillion dollars. 

A derivative is essentially a bet.  They were used responsibly in business for centuries as insurance against loss.  For example, in a simple derivative contract a farmer might bet against the success of his own crop to insure that if his crop fails he will not be at a total loss.  If the crop is productive that year, he loses the bet but reaps a profit from sale of his product.  If the crop fails, on the other hand, he can collect on the bet and make up for his loss of profit.  Derivatives provide a way to produce even returns in markets that are subject to uneven productivity.

One of the problems with today’s derivatives market is that it has expanded from its initial purpose of hedging and simple speculation to allow for betting on just about anything financial.  During the housing bubble we saw banks like Goldman Sachs betting on the failure of the very products they were selling as “AAA” rated safe investments.  They made a ton of money on the failure of their own financial products in this way, which represents just a little bit of a conflict of interest. While the housing-related derivatives have taken up less of the overall market, the overall market continues to grow. Today’s synthetic derivatives market even allows for betting on other people’s bets. This has created a multi-level ponzi scheme of derivatives that are based on the success of other derivatives, using huge degrees of leverage at every layer. In addition to remaining vastly unregulated and opaque, the market for the creation and exchange of derivative contracts operates much like the roulette wheel at a Las Vegas casino.

Basically, there is no other game in town to realize the kind of profits banks and their clients demand these days, so the roulette table is the place to be. Part of the attraction for the banks is that derivatives are traded over the counter, not through regulated exchanges, and the notional value of derivatives is recorded OFF the balance sheet of an institution, although the market value of derivatives is recorded ON the balance sheet. Attempts at regulation have been effectively blocked. So, we don't really know how much of the Federal Reserve's stimulus has gone into the Black Hole which represents the big banks gambling addiction in derivatives.

Where else has all the Fed stimulus money been going? The Fed is exchanging about $4 billion in newly created money every business day for various types of bonds. All else being equal, the Fed's bond buying puts more money in investors' hands to buy other assets, including stocks.

So let us follow that newly created money. The major dealers who sell the bonds to the Fed can take that money and buy other bonds in the open market. The new seller then gets paid with that newly created money, which in the bank clearing system, acts just the same as money you and I work for.

To make this really simple, the Fed creates $4 billion a day and eventually some of that money goes into equities. And that, of course, helps keep stock prices elevated. So it doesn't matter that we are having major problems with the underlying economy and markets that normally would depress stock prices. This is why you don't fight the Fed.

So, a large, not-quite-sure-how-much, but large amount of the Fed's stimulus efforts went to making sure the derivatives Black Hole did not swallow the entire universe; and that hasn't happened yet, so good job. Another large chuck of change goes to propping up bonds and equities and the Wall Street traders that trade them; and the major market indices are close to record highs, so good job. But the broader economy sucks; so in this regard the Federal Reserve gets very low marks indeed.

America cannot succeed when a shrinking few do very well and a growing many barely make it. Yet that continues to be the direction we’re heading in. The top 1 percent of earners’ real wages grew 8.2 percent from 2009 to 2011, yet the real annual wages of Americans in the bottom 90 percent have continued to decline in the recovery, dropping 1.2 percent between 2009 and 2011. In other words, we’re back to the widening inequality we had before the debt bubble burst in 2008 and the economy crashed. Not even the very wealthy can continue to succeed without a broader-based prosperity. That's a big reason why the recovery has been so weak; why the economy shrank in the fourth quarter.

Of course, fiscal policy has been ugly. As I said earlier, tax hikes combined with government spending cuts is a quick formula for negative growth. And the Federal Reserve standing pat won't get the job done either.

Thursday, April 19, 2012 - Say on Pay Just Says No to Citigroup, BofA Loses by Winning, and the Risky World of Derivatives

DOW – 68 = 12,964
SPX – 8 = 1376
NAS – 23 = 3007
10 YR YLD -.03 = 1.95%
OIL -.01 = 102.66
GOLD +.60 = 1643.60
SILV + .17 = 31.90
PLAT + 3.00 = 1587.00

Vikram Pandit, the CEO of Citigroup was “this close” to a $15 million dollar payday. And then shareholders slammed on the brakes and demanded the amount be toned down. It might be a trend. Wells Fargo and Bank of America will ask shareholders to vote on executive pay in coming weeks, and the results at Citi might influence the voting at Wells and BofA. Yesterday, shareholders rejected the compensation plan of regional bank FirstMerit Corp., of Akron, Ohio. The bank gave its CEO a pay raise to $6.4 million last year from $5.5 million, while its stock fell 20 percent.

“Say-on-Pay” votes by shareholders were a requirement of the Dodd-Frank financial reform Act, and it looks like 90% of the compensation packages are winning approval, but the margin is slim. The Occupy movement plans to protest at 36 shareholder meetings this spring and the investment community seems to be waking up from a long nap of disengagement. The California Public Employees Retirement System, or CalPERS, voted no on the Citigroup pay measure because Citi “has not anchored rewards to performance.”

Unfortunately, the only reason CalPERS voted against the pay package was because Pandit's performance was beyond incompetent. What is the appropriate role for CalPERS? Shouldn't they stand up for their members? Chief executives at some of the nation's largest companies earned an average of $12.9 million in total pay last year -- 380 times more than a typical American worker. Average CEO pay rose 14% compared to 2010, when they earned $11.4 million on average. Disparity is one thing, under-performance is another.

Pandit raked Citigroup shareholders over the coals. He sold his hedge fund and pocketed $165 million, then he took a $37 million dollar signing bonus, then he lost hundreds of millions of Citi's money, and he presided over some of the worst possible performance you can imagine for a shareholder. On a split adjusted basis, one share of Citigroup stock was valued at $536 five years ago; today it is worth $34. Last month, Citigroup failed the Federal Reserve's Stress Test – that means no dividends for shareholders. The vote against Pandit's pay package was not about income inequality, it was only about the truly terrible job Pandit has done, driving share price into a ditch, failing to achieve regulatory minimums, pushing one of the biggest banks in the world to the very edge of insolvency. Citi would be insolvent right now if not for ongoing government support.

Bank of America issued a first quarter earnings report today. The report included this gem: “Results Include Negative Valuation Adjustments of $4.8 Billion Pretax, or $0.28 Per Share, From the Narrowing of the Company’s Credit Spreads.” I'll try to explain: If a bank’s own debt securities are falling in price, it effectively means its liabilities – the amount it owes — are worth less. Accounting rules say that’s positive for the balance sheet, and the decline in liabilities can therefore show up as a gain in the income statement. But in the first quarter, certain Bank of America debt securities were worth more, which means those liabilities increased in value, and that therefore produced a loss, of $4.8 billion, in earnings.

Not all of a bank’s debt gets adjusted in this way. And, yes, it seems absurd that falling debt prices – a sign that investors think a bank is less creditworthy – should lead to a gain in profit. In theory, if Bank of America defaulted on its corporate bonds, they could post a huge profit and the CEO would probably get a bonus.

At some point, there will be another major bank failure; we can't continue to allow such insane accounting to continue at the banks; we've gone from sublime to absurd to just downright stupid. And even worse, it's really dangerous. A listener passed along an article from Seeking Alpha that looks at the risk we are really exposed to.

The entire US GDP is less than $15 trillion each year. The gross notional amount of derivatives issued in the USA is more than $291 trillion. Now people say you can’t use the “notional” value, that it's misleading. Another number is the "net current credit exposure" (NCCE) which is only about $370 billion (only); this number is supposed to represent risk imposed by derivatives, but it doesn't provide the ultimate exposure to loss, it just measures the cost of unwinding the contracts. Then there are “value at risk” calculations; those are very inconsistent; the banks tried to use “value at risk” about 4 years ago to measure the fallout from the subprime mortgage market. That didn't work.

In reality, it is impossible to know the true risk of $291 trillion in New York issued derivatives. And there is more than $400 trillion more in London based derivatives. And even if nobody knows the true risk, it is highly likely that a fairly large increase in interest rates would be enough to trigger trillions of dollars in payments. And that means the Federal Reserve can’t raise interest rates. Even if the dollar comes under relentless selling pressure, the Fed can't raise rates. Even if inflation jumps, the Fed can't raise rates.

And part of the problem is where the banks hold their derivatives. All the too-big-to-fail banks are using FDIC-insured depository divisions to house derivatives, with the exception of Morgan Stanley (which uses its SIPC-insured division). That provides them with lower collateral requirements because FDIC depositary units usually have higher credit ratings than investment banks or bank holding companies. Insolvency laws provides priority to derivatives counter-parties over the FDIC. If and when a bank is liquidated, the FDIC will be on the hook to repay depositors, but the failing bank will be stripped of all assets.

Now imagine there is some event that triggers a 1 percent loss in derivatives, or about $3 trillion. The FDIC has about $40 billion in readily available funds, plus a $500 billion dollar line of credit with the Treasury, and ultimately the full faith and credit of the US government. OK, it is highly unlikely that there will be an event that would trigger that big of a problem, what about 0.1% in losses. Still plenty big enough to effectively destroy the FDIC and tip the dominoes in a long, cascading line of defaults.

And don't forget there are more than $400 trillion in derivatives written in London; those are unregulated; good luck trying to find out details on that paper, but you can bet that the US taxpayer is ultimately on the hook for those bets. Part of the exposure is held on the balance sheets of foreign, mostly European banks, including Deutsche Bank, PNB Paribas, Credit Suisse, UBS, and the other usual suspects. But, a large number of seemingly foreign derivatives is also hidden inside bank divisions, owned by American institutions, who do business in London. Such derivatives are not reported to the Fed, the OCC or the FDIC. Lenient British banking laws insure that these opaque obligations are not subject to public scrutiny.

What could go wrong?

Today, french government officials said the rumor of a credit downgrade is unfounded. There is no new information from any rating agency that would point in this direction. French bond yields jumped on the downgrade talk before recovering. The downgrade speculation comes just days ahead of the first round of voting in France's presidential elections. Standard & Poor's stripped France of its triple-A rating in January. Moody's put a negative outlook on France's triple-A rating in February. Spain's debt problems aren't going away any time soon. It just takes a small glitch to create a big problem.