Wednesday, November 21, 2012 - Of Cliffs and Helicopters

Of Cliffs and Helicopters
by Sinclair Noe

DOW + 48 = 12,836

SPX + 3 = 1391
NAS + 9 = 2926
10 YR YLD +.03 = 1.69%
OIL + .95 = 86.40
GOLD + 1.10 = 1730.20
SILV + .20 = 33.49

Israel and Hamas agreed to bring to an end more than a week of air strikes and missile attacks. A truce was declared; now we'll see if it holds. The agreement aims to halt air strikes that have left more than 150 people dead in Gaza and rocket attacks that have killed five Israelis. Israel has hit more than 1,500 targets, and Palestinians launched more than 1,400 missiles.

Secreatary of State Hillary Clinton said that she welcomed the accord and expressed hope it will “move us closer to a comprehensive peace.”

“In the days ahead, the United States will work with partners across the region to consolidate this progress, improve conditions for the people of Gaza, and provide security for the people of Israel,” she said.

The accord says that Israel shall stop all hostilities on the Gaza Strip, land, sea and air, including incursions and targeting of individuals. It also says that “all Palestinian factions shall stop all hostilities from the Gaza Strip against Israel, including rocket attacks and attacks along the border.”

Israeli Prime Minister Netanyahu thanked President Obama and Egyptian President Mohamed Mursi for their work to end the violence. There was tremendous US pressure on the Egyptians, who in turn pressured Hamas to accept terms which are not set in stone, including it seems regarding the Gaza blockade. The Obama administration has now placed itself as the guarantor of the agreement’s terms, including the halt in rocket attacks, and they are probably going to be tested very quickly.

Volume was light today due to the impending Thanksgiving holiday. NYSE trading volume finished about 30% below the 10-day moving average, near one of the lowest volume days of the year. From the early morning until the equity market closed, S&P 500 futures traded in a narrow 5.5 point range.

Because of the Thursday holiday, the weekly jobless claims report was released a day early. The Labor Department showed a decline to 410,000 weekly claims, down from last week's claims that saw a revision up to 451,000 from 439,000. Other data showed manufacturing picked up at its quickest pace in five months in November, while the Thomson Reuters/University of Michigan's final reading for November showed the consumer sentiment index improved only slightly from the previous month. The focus will likely turn to retailers on Friday as analysts try to assess how strong the holiday shopping season will be this year.

Overnight, equity futures dropped a sharp 1% after European finance ministers announced that they had not reached a definitive deal on the funding gap that is currently facing Greece. While there was progress made, no final deal was reached. However, the wording of the press release suggested that the overall basics of the deal were agreed upon, but the mode of payment was not. The next opportunity to come to a final agreement comes next Monday at another emergency meeting of EU finance ministers. Also in Greece, additional news headlines surfaced that the Troika of Greek creditors were taking another look at the proposal of a Greek debt buyback or lowering interest payments on bailout loans.

There has been disagreement among the ministers and the IMF on how to make Athens' debt manageable. The eurozone ministers are in favor of giving Greece an extra two years, to 2022, to bring its debt down to 120 percent of gross domestic product from the 176 percent forecast for this year. The IMF has resisted such an extension.

Agreement on this issue is needed for the group of creditors to pay Greece the next batch of its rescue loans, expected to amount to $57 billion. Greece needs the money to avoid bankruptcy. Greece has been relying since 2010 on international bailout loans, under terms supervised by the so-called troika - the IMF, the European Central Bank and the European Commission, which is the 27-country European Union's executive branch. Two weeks ago, Greece's coalition government narrowly succeeded in passing a $20 billion package of budget cuts, tax increases and reforms in order to secure the latest loan payment.

The question of debt sustainability is as important as it is divisive: If Greece's debts can't be reduced to a level where the country can afford to pay them, the billions of euros in bailout loans given to Greece will have been wasted. One of the reasons Greece is not expected to reduce its debt to 120 percent of GDP by 2020 is that its austerity program of spending cuts and tax hikes is hurting the economy, which faces a sixth year of recession in 2013.

Japan's exports continued to fall for the fifth straight month. Japan is faced with slowing demand from its main trade partners China and the US as well as continued slowdowns from Europe. Yesterday, the Bank of Japan declined to ease further despite increased calls for monetary stimulus from Japan's opposition party.

Tomorrow US markets will be closed for the Thanksgiving holiday. On Friday, US markets will be open for a half day, closing at 1:00 p.m. ET. There will be no economic data from the US on Friday. 

Time won't stop for the rest of the world, however. The rest of the world will issue economic reports, and then Monday, we'll get back to the novella that is the fiscal cliff. What is it about fiscal policy that brings out the crazy?

Which brings us to the fiscal cliff; or slope, which is more accurate and avoids creating the false impression that all is lost come January 1. The tax increases and spending cuts in place promise to repeat the mistakes of the UK and the Eurozone by pivoting too fast and too hard into the realm of fiscal austerity.  A solution to the fiscal cliff means smoothing the path to fiscal consolidation (optimally, with no austerity in the near term, but I don't see that as an outcome). Why? Because the parameters of the debate have already been determined. Just listen to what former Federal Reserve Chairman Alan Greenspan says:

All of the simple low hanging fruits have been picked and the presumption that we are going to resolve the big issue on spending by making a few little twitches here and there I think is a little naive. If we get out of this with a moderate recession, I would say that the price is very cheap. The presumption that we will solve this problem without paying I think is grossly inappropriate...I think the markets are getting very shaky. And they are getting shaky because I think fiscal policy is out of control. And I think the markets will crater if we run into any evidence that we cannot solve this problem.

If markets are shaky, they are shaky because participants recognize the recessionary impact of this level of fiscal austerity and they don't like it.  Market participants want Congress and the President to do exactly what Greenspan claims is impossible, minimize the impact of spending cuts. We need to find a cure for the crazy that some fall into whenever the topic is fiscal policy.

It was 10 years ago today that Mr. Bernanke gave his speech titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here” as at the time some “expressed concern that we may soon face a new problem, the danger of deflation or falling prices” as reported inflation rates were low at the time as the economy was in its post stock market bubble malaise. In the speech he said, “US dollars have value only to the extent that they are strictly limited in supply. But the US Government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper money system, a determined government can always generate higher spending and hence positive inflation.”

He then went on to ironically say, “Of course, the US government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).” The CRB index proceeded to rally 159% over the following six years and gold, on that day in 2002 at $317.60, has ‘only’ risen 444% since. We have now 10 years of economic results and the attached debt due to the Fed’s attempt to avoid deflation after the 2001-2002 stock market bubble popping induced recession.

Anyway, that speech ten years ago today, earned Bernanke the nickname, Helicopter Ben.

Yesterday, Bernanke spoke to the NY Economic Club and in a question-and-answer session, Bernanke warned that Fed policy could not protect the economy if it goes over the cliff. “I don’t think the Fed has the tools to offset that,” he said. That's not exactly true. He still has a printing press. He still has a helicopter.

Tuesday, November 20, 2012 - Extracting Meaning

Extracting Meaning

by Sinclair Noe

DOW – 7 = 12,788
SPX +0.92 = 1387
NAS + 0.61 = 2916
10 YR YLD + .04 = 1.66%
OIL + 1.22 = 86.67
GOLD – 3.80 = 1729.10
SILV + .08 = 33.29

There may be a ceasefire in the Middle East. An official for Hamas says a ceasefire deal has been reached. Officials for Israel and Egypt say not quite, some details are being worked out. Israel pressed on with its strikes in Gaza on the seventh day of its offensive and Palestinian rockets still flashed across the border. Secretary of State Clinton is in Israel to help broker a deal. A ceasefire may be announced within the hour, but that would just be a small step; actually enforcing the ceasefire would be more telling.

Federal Reserve Chairman Bernanke delivered a speech today to the New York Economic Club. Bernanke said one reason the recovery has been so disappointing is that the financial crisis appears to have lowered, at least for a time, how fast the economy can grow over the long run.

The crisis has reduced labor force participation and lowered productivity as businesses have trimmed investment. This suggests that the nation’s potential output has grown more slowly than expected in recent years. Potential output combines the economy’s long-run productivity rate and labor force growth. This means the economy has to grow faster than potential to bring down the unemployment rate. In some ways, this is Bernanke making the case against austerity and for stimulus.

However, Bernanke did not take sides on the fiscal cliff, only to say that politicians should not go over the cliff: “Uncertainty about how the fiscal cliff, the raising of the debt limit and the longer-term budget situation will be addressed appears already to be affecting private spending and investment decisions, and may be contributing to an increased sense of caution in financial markets.” He urged the members of Congress not to kick the can down the road. He said that putting off policy choices would only “prolong and intensify these uncertainties.”

In a question-and-answer session, Bernanke warned that Fed policy could not protect the economy if it goes over the cliff. “I don’t think the Fed has the tools to offset that,” he said. That's not exactly true. The Fed does have tools. The question is whether the Fed is willing to use them.

On the upside, Bernanke said not going over the fiscal cliff could be a good thing: “A plan for resolving the nation’s longer-term budgetary issues without harming the recovery could help make the new year a very good one for the American economy.”

Morgan Stanley has issued a report on the global economy and they are somewhat less sanguine than Bernanke. Morgan Stanley warns: the global economy is likely to be stuck in the "twilight zone" of sluggish growth in 2013, but if policymakers fail to act, it could get a lot worse. The bank's economics team forecasts a full-blown recession next year, under a pessimistic scenario, with global gross domestic product likely to plunge 2 percent.

The report says that: "More than ever, the economic outlook hinges upon the actions taken or not taken by governments and central banks.” Under the bank's more gloomy scenario, the US would go over the "fiscal cliff" leading to a contraction in US GDP for the first three quarters of 2013. In Europe, the bank's pessimistic scenario assumes a failure of the European Central Bank in cutting rates and a delay of its bond-buying program. The bank's most optimistic scenario forecasts GDP growth of 4 percent in 2013 compared to around 3.1 percent this year.

John Templeton, one of the greatest investors of all time, said that investors should buy at the point of maximum pessimism. Easy to say, hard to do, unless you have some unique insight or knowledge.

Prosecutors have charged a former SAC Capital employee with insider trading in a series of transactions that hedge fund titan Steven Cohen had personally signed off on.

In what they called "the most lucrative" insider-trading scheme ever, prosecutors alleged that Mathew Martoma helped Cohen's firm avoid losses and reap profits totaling $276 million in the summer of 2008 by using insider tips he got from a doctor about Elan Corp and Wyeth.

Martoma is the fifth person associated with SAC Capital, one of the most widely followed and influential hedge funds, to be charged with insider trading in either a criminal or civil proceeding. He had worked for a unit of SAC Capital called CR Intrinsic Investors in Stamford, Connecticut until 2010.

The criminal complaint against Martoma, while not mentioning Cohen by name, refers to him as the "owner" of the hedge fund and makes clear that Cohen and Martoma talked often about the fund's trading in shares of Elan and Wyeth. The court papers do not indicate that Cohen had knowledge of how Martoma obtained his information.

According to court papers, Martoma spoke in July 2008 to the "hedge fund owner" and recommended selling shares of Elan and Wyeth before a negative announcement on clinical trial results for an Alzheimer's drug jointly developed by the two companies. CR Intrinsic had initially taken long positions in Elan and Wyeth stocks before reversing itself over the course of one week, selling some stock and building up massive short positions that accounted for one fifth of all trading in Elan.

Martoma's lawyer, Charles Stillman, said his client was an "exceptional portfolio manager" and he is confident Martoma will be exonerated. A spokesman for SAC Capital said "Mr. Cohen and SAC are confident that they have acted appropriately and will continue to cooperate with the government's inquiry".

The charges against Martoma stem from the U.S. government's long-running investigation into improper trading in the $2 trillion hedge fund industry, which the Federal Bureau of Investigation has called, Operation Perfect Hedge. To date, the investigation has led to more than 50 convictions. Two former traders, Noah Freeman and Donald Longueuil, pleaded guilty to insider trading charges last year. Jon Horvath, a former analyst at a division of SAC pleaded guilty to insider trading charges in September. Another former SAC Capital employee, Jonathan Hollander, settled civil charges of insider trading last year with the SEC.

Hewlett-Packard acquired British software company Autonomy last year for $10.3 billion and today HP wrote that investment down by $8.8 billion. Apparently $5 billion of the $8.8 billion dollar writedown was due to: “accounting improprieties, misrepresentations and disclosure failures” at Autonomy.

I don't know much about HP and even less about Autonomy. Autonomy described itself in its last annual report as “the leading provider of Pan-Enterprise Search and Meaning Based Computing (MBC) solutions. Autonomy’s unique Intelligent Data Operating Layer (IDOL) platform enables organisations to harness the full richness of human information by extracting meaning from the mass of unstructured information they handle every day, which analysts estimate to constitute over 80% of all enterprise data.”

I don't know what that means but I don't think computers can harness the full richness of human information, although I might be wrong. If the software was so great, then why didn't HP use it to extract the full meaning of an $8.8 billion dollar writedown? Maybe the next multi-billion dollar acquisition will be software that can tell the difference between artificial intelligence and natural stupidity.

Almost 200 nations will meet in Doha from 26 November to 7 December to try to extend the Kyoto protocol, the existing plan for curbing greenhouse gas emissions by developed nations that runs to the end of 2012.

On Monday, the World Bank said current climate policies meant the world was heading for a warming of up to 4C by 2100. That will trigger deadly heat waves and droughts, cut food stocks and drive up sea levels.

Today, a coalition of the world's largest investors called on governments to ramp up action on climate change and boost clean energy investment or risk trillions of dollars in investments and disruption to economies.

In an open letter, the alliance of institutional investors, responsible for managing $22.5 trillion in assets, said rapidly growing greenhouse gas emissions and more extreme weather were increasing investment risks globally. The group called for dialogue between investors and governments to overhaul climate and energy policies. The group said the right policies would prompt institutional investors to significantly increase investments in cleaner energy and energy efficiency, citing existing policies that have unleashed billions of dollars of renewable energy investment in China, the United States and Europe.

And yet... change seems to move at a glacial pace.

Economists and financial theorists still do not get the vital interconnection between the true nature of the economic system and a healthy ecosystem. What will it take? One complex, indivisible, systemic crisis. We are now a couple of weeks into the aftermath of Hurricane Sandy and no one has yet improved upon the analysis of Bloomberg Businessweek's cover story on November 1 : "It's global warming, stupid."

We need an economy of sufficiency that does not demand exponential growth of material output from finite resources on a planet that is fixed in scale. This leads us well past pricing externalities; there are some things that go beyond pricing.

I thought I'd throw that out there because next week 200 nations will meet in Doha and it probably won't get much media coverage. 

Monday, November 19, 2012 - Debtmageddon: the Non-Problem Problem

Debtmageddon: the Non-Problem Problem

by Sinclair Noe

DOW + 207 = 12,795
SPX + 27 = 1386
NAS + 62 = 2916
10 YR YLD +.04 = 1.61%
OIL + 1.22 = 86.67
GOLD + 18.20 = 1732.90
SILV + .80 = 33.21

Pete Domenici and Alice Rivlin are co-chairs of the Bipartisan Policy Center for Debt Reduction Task Force, offering the following recommendations in an article in the New York Times over the weekend:

Economic growth must precede full-scale debt restraint.

Congress should take action now to pass legislation phasing in tax reform that yields new revenues and restructuring entitlements to curb the continued growth of federal spending, particularly for health care.

We cannot resort to such ham-handed mechanisms as the approaching sequester cuts, large across-the-board tax increases and other elements of the “fiscal cliff.”

In late 2010, the task force recommended a holiday from the full 12.4 percent Social Security payroll tax, not the partial 2 percent cut that Congress ultimately passed. The idea is that whether it comes in the form of a payroll tax holiday, an income tax rebate or another similar mechanism, the most pressing priority is to get the economy out of “stall speed.”

The task force also suggested a possible “framework” for the lame-duck Congress to pass a modest down payment on deficit reduction in December, while pursuing a comprehensive agreement, a “grand bargain” of sorts, in 2013.

If I may break it down in a nutshell; growth before austerity.

Federal Reserve Board Chairman Ben Bernanke will travel to New York City tomorrow to deliver a speech in which he will explain that the central bank is not having any second thoughts about its ultra-easy monetary policy stance. Bernanke will likely use his speech to emphasize once again that monetary policy will remain highly accommodative and will stay that way even after the recovery strengthens. Fed watchers generally think the Fed will boost its easing power in December by converting its expiring Operation Twist program into an outright Treasury purchase plan program. At the moment, the Fed is buying $45 billion of Treasurys per month under this plan, but the purchases are offset by sales of short-term securities. Don't expect any groundbreaking news from the Fed head, but expect a tone generally supportive of further easy monetary policy. The next Fed FOMC meeting is December 12-13.

Bernanke and the FOMC will likely adopt a wait and see attitude. They will wait to see if the dysfunctional Congress will really run like lemmings over the fiscal cliff. They might, but we have to let it play out. Policymakers are faced with a new round of momentous choices – how to balance the imperative for job creation with the pressure to address budget shortfalls. There will be temptations to hold firm and there will be temptations to cut a deal. The whole framework around cutting a deal is based on the idea that we must reduce the deficit and there must be fiscal responsibility. You could replace fiscal responsibility with austerity for the purposes of discussion.

The federal budget deficit isn’t the nation’s major economic problem and deficit reduction shouldn’t be our major goal. Our problem is lack of good jobs and sufficient growth. Deficit reduction leads us in the opposite direction — away from jobs and growth. Too much deficit reduction, too quickly would suck too much demand out of the economy; however, more jobs and growth will help reduce the deficit. With more jobs and faster growth, the deficit will shrink as a proportion of the overall economy. Europe offers the same lesson in reverse: Their deficits are ballooning because their austerity policies have caused their economies to sink. Yes, they are cutting spending but their economies are shrinking faster than the spending cuts; and the debt-to-GDP ratio grows. In fact, if there was ever a time for America to borrow more in order to put our people back to work repairing our crumbling infrastructure, it’s now.

And yet, there is still a loud chorus for debt reduction, and the media has bought into the idea, or at least they've hooked onto the fear factor involved with the phrases “fiscal cliff” and “debtmageddon”. They repeat the talking points of a small cottage industry that has sprung up around debt reduction. They say that it is a given that tax rate will go up; they say it is a given that spending will be cut; it's a given that deficits are bad. There has been very little discussion and debate about the dangers of deficit reduction. And so, the closest we've come to a serious debate is to discuss the timing: It all boils down to timing and sequencing: First, get the economy back on track. Then tackle the budget deficit.

Sounds good, but why does the deficit have to be tackled? Deficit hawks routinely warn unless the deficit is trimmed we’ll fall prey to inflation and rising interest rates. But there’s no sign of inflation anywhere. The world is awash in underutilized capacity As for interest rates, the yield on the ten-year Treasury note is about 1.6%, near record lows.

We certainly don’t want to go where Europe has been going lately. They’re a great example of how NOT to manage your way out of a debt crisis. It would take superb timing to avoid the fate of the Eurozone nations by planning for deficit reduction later, or at all? The assumption here is that there must and will be a time when we can reduce the deficit without harming the economy. What if there’s no such time? What if any substantial deficit reduction to under 4% of GDP, a figure envisioned in most of the deficit reduction plans being offered, means making the private sector poorer in the aggregate? Wouldn't that get priced in?

That's not just a theoretical question. Right now, the US imports more than it exports in an amount greater than 4% of GDP. If we continue to do so, and the Government deficit is forced down to a number below 4% of GDP, then a private sector surplus in the aggregate will be literally impossible to attain, and, if we continue with such a policy, year after year, the private sector will lose more and more of its net financial assets as the Government eats the private economy in a fit of fiscal irresponsibility, that since it’s now way past 1984, the austerity advocates label fiscal responsibility.

Public investments that spur future job-growth and productivity shouldn’t even be included in measures of government spending to begin with. They’re justifiable as long as the return on those investments – a more educated and productive workforce, and a more efficient infrastructure, both generating more and better goods and services with fewer scarce resources – is higher than the cost of those investments.

In fact, we’d be nuts not to make these investments under these circumstances. No sane family equates spending on vacations with investing in their kids’ education. Individuals can differentiate between spending and investing. Yet the politicians can't seem to do that with our federal budget.

I suspect the real concern over a “deficit problem” is due to fear of the markets and,maybe, just maybe there is no problem with running continuous deficits provided the Fed, along with the Treasury, control interest rate targets, and that the bond markets are powerless to impose their will on Mr. Bernanke and the Treasury Secretary if they want to keep rates near zero, or at any other level of interest they would like the US to pay. Well, guess what, the bond markets and the ratings agencies are basically powerless to drive up interest rates against the combined determination of the Fed and the Treasury to keep them low.

Of course, too much deficit spending can cause inflation, but the remedy for that is to raise specific taxes and lower specific spending in such a way that price stability and full employment result from fiscal policy. The best fiscal policy is one that spends what the US needs to spend to solve its serious problems.

Gross domestic product probably increased at about a 2.9 percent annual rate in July-September, according to economists from Goldman Sachs and Barclays. That would be the fastest quarterly growth this year, beating the Commerce Department’s initial estimate of 2 percent. Help is coming from a housing recovery, strengthening job market and healthier household finances that are driving gains in consumer confidence and spending. While the damage from Sandy and an anticipated tightening of fiscal policy mean growth will decelerate this quarter and next, the economy may emerge on stronger footing in the second half of 2013.

Sales of previously owned homes climbed in October. Purchases increased 2.1 percent to a 4.79 million annual rate. According to the report from the National Association of Realtors property values rose over the past 12 months by the most in seven years as inventories dropped to the lowest level in almost a decade.

Thirteen cents of every retail dollar is spent at gas stations, but that level has stagnated in recent years amid weaker demand. Americans spent some $47.85 billion at gas stations in October; that represents 13% of the $367.56 billion spent at all retail locations in the month. That share has increased a bit in recent months, but overall it’s little changed over the past two years. In the third quarter it was 12.5%, the same level as the first quarter of 2011.

The American Petroleum Institute reports US oil demand fell 2.3% in October from a year earlier, to 18.4 million barrels a day. Demand in the first 10 months of the year was 2.1% below the same period in 2011. A modest economic recovery and continued high unemployment, as well as higher fuel-economy standards, have reduced demand.

Another factor in reduced demand for gasoline, in relation to retail sales, is that e-commerce continues to grow. More than five cents of every dollar spent at retailers in the July-to-September period was spent online. That share has basically quintupled in the past decade, and while growth slowed slightly during the recession, it has continued to steadily march upward. The more goods people can get online, the less time they need to spend in the car traveling to brick-and-mortar retailers.

The shadow banking industry has grown to about $67 trillion, $6 trillion bigger than previously thought. The Financial Stability Board, or FSB says the size of the shadow banking system, which includes the activities of money market funds, monoline insurers and off- balance sheet investment vehicles, “can create systemic risks” and “amplify market reactions when market liquidity is scarce.”

The FSB, a global financial policy group comprised of regulators and central bankers, found that shadow banking grew by $41 trillion between 2002 and 2011. The share of activity based in the US has declined from 44 percent in 2005 to 35 percent in 2011, moving to the UK and the rest of Europe.

While regulatory watchdogs believe they have reined in excessive risk-taking by banks in the wake of the collapse of Lehman Brothers in 2008, they are concerned that lenders might use shadow banking to evade the clampdown. Already, the European Union is planning to target money market funds in a first wave of rules for shadow banks next year.

The FSB also targeted repurchase agreements and securities lending for tougher rules, recommending that regulators implement minimum standards for calculating losses on the different types of collateral used in the transactions.

Repurchase agreements are contracts where one investor agrees to sell a security and then buy it back at a future date and a fixed price. Securities lending agreements involve institutional investors such as pension funds lending financial instruments against cash collateral. The group is also concerned that regulators are unable to monitor the scale of the trades. 

The FSB says large firms should disclose more information about the deals to investors and may be required to publish regular statements detailing how much collateral they have and what it is used for. The need here is simple: a lack of transparency and disclosure results in counterparty risk, which in turn can lead to credit freeze, runs, and a general repeat of 2008. In other words, the FSB report tells us that the problems of 2008 haven;t been fixed, they've only grown in size.

New research from the Federal Reserve Bank of New York finds cheaper monthly mortgage payments significantly reduce mortgage default risk even when the principal value of the home stays the same. The report was based in part on findings on the performance of Alt A adjustable-rate mortgages, between 2008 and 2011.

The report says: “Interest rate changes dramatically affect repayment behavior. Our estimates imply that cutting a borrower’s payment in half reduces his hazard of becoming delinquent by about two-thirds. Government or lender programs that allow underwater borrowers to refinance at a lower rate, or loan modifications that lower the interest rate, have the potential to significantly reduce delinquencies, and the view that principal reduction is the only way to meaningfully reduce defaults is incorrect.”

Here's the scary part; they're just figuring this out.  Years ago, most people learned that when the loan sharks put the rates too high, it resulted in default; when rates were lower and closer to reasonable, people tended to pay their debts. 

Friday, November 16, 2012 - Externality and Inequality

Externality and Inequality

by Sinclair Noe

DOW + 45 = 12,588
SPX + 6 = 1359
NAS + 16 = 2853
10 YR YLD -.02 = 1.57%
OIL + 1.05 = 86.50
GOLD – 2.40 = 1714.70
SILV - .29 = 32.41

Top Congressional leaders met with President Obama today at the White House. Democrats said they recognized the need to curb spending. Republicans said they agreed to put revenue on the table. They sang a chorus of Kumbaya; they left the meeting and talked to the press. Mitch McConnell, John Boehner, Nancy Pelosi and Harry Reid all shared the microphone; both sides pledged cooperation; both sides agreed that driving over the fiscal cliff was a big bucket of crazy; no blood was shed today. Don't hold your breath.

Former Federal Reserve Chairman Alan “Bubbles” Greenspan says allowing taxes to rise would be a small price to pay to get lawmakers to accept spending cuts on entitlement programs, even if it leads to a moderate recession. So, what is on the negotiating table is starting to emerge, even though the goal posts are still moving targets. What is most interesting at this point is not the proposals that are on the table but the proposals that never make it to the table. How can we really have a debt to GDP ratio problem when we have a non-convertible fiat currency, a floating exchange rate and debts in currencies not our own? Yea, that isn't going to be part of the discussion.

And that brings us to today's main topic: externalities and inequality.

You may have noticed that the markets don't always produce the best possible social outcomes. The pollution generated by a factory imposes costs on those who live downstream or in the path of its airborne emissions. The risks assumed by banks leading up to the recent financial crisis imposed costs on just about everybody. Market transactions often generate “externalities”, or side effects, sometimes positive but often negative, that affect people who do not participate in the transaction. What's the solution? Well if you want less of something you tax it. You could tax the negative externalities and subsidize the positive externalities.

Does the fact that hedge-fund manager rakes in 100 or 1,000 times what office manager earns impose costs on everybody else? Plenty of Americans think not. Defenders of our income inequality point out that a free-enterprise system requires some inequality. Unequal rewards give people an incentive to work hard and acquire new skills. They encourage inventors to invent, entrepreneurs to start companies, investors to take risks. It’s fine in this view that some people get astronomically rich.

On the other side, many of us have a gut feeling that inequality has gone too far. Our times are reminiscent of the Gilded Age’s worst excesses.

The conventional strategy for fighting inequality is to tax the rich. The idea is based on a foundation of fairness, and the question of what’s fair and what’s unfair turns out to cut different ways, depending on your point of view. You may find it unfair that the very rich take in so much more than others. Somebody else might wonder why the rich should be taxed so heavily. Don’t they already pay disproportionately more than everyone else? These arguments hit a dead end. So, the lemming politicians are ready to run off a fiscal cliff over marginal top tax rates of 35% or 39%, that have already demonstrated negligible effects in reducing inequality. No one even discusses top rates that might make a difference. So what we need to look at is how skewed income distribution imposes costs on the rest of us.

Between the end of World War II and 1973, the top marginal tax rate never dropped below 70%, and for a while it was more than 90%, and growth in real domestic product per capita averaged close to 2.5%; in other words: Good Times. Since the the economy has continued to grow, an average of about 2.1%, but the median household income has only increased 0.4%. The average income of the top 1% has increased more than 300% but the median household income has increased by less than 20%. From 1975 to 2008, the median household income rose by a total of $8,000 (in today’s dollars). Had the distribution remained the same as it was in the postwar years, the increase would have been $40,000. Instead of its current level, $50,000, the median income of US households today would be $86,400. So, that might be considered a real dollar cost.

Also, there is the cost of people who focus narrowly on getting richer. For young people, going where the money is becomes more attractive than a career in science, education, or public service. As late as 1986, only 18 percent of Harvard graduates planned any sort of business career. In 2011, the figure was 41 percent, including 17 percent going into finance.

The new incentives affect the behavior of anyone with a decent shot at getting rich. CEOs of large corporations expect astronomical compensation packages. Wall Street executives pursue riskier lines of business in search of higher profits than they could earn through traditional banking or brokerage; and if they commit fraud, they pay a partial fine and move on to their next risky venture. Doctors and lawyers have an incentive to train for lucrative subspecialties, leaving a shortage of general practitioners and public defenders. All these brain drains and unnecessary risks impose costs on everyone else.

There is yet another cost to democracy. Despite fundamental principles such as one person, one vote, the wealthiest Americans have always wielded disproportionate political influence, but with Buckley v. Vallejo and Citizens United, the courts have granted personhood to corporations and ruled that money is speech not property. The result is politicians are bought and paid for, or at the very least, influenced by legions of lobbyists.

Little wonder, then, that disaffected citizens on the right, on the left, and in the middle; whatever their views on inequality, believe that the very rich and organized business interests have hijacked America’s political process. Sustained economic growth depends on open and inclusive political institutions.

Based on the examples it appears that a highly skewed income distribution results in negative political externalities. The most evident solution? Slap a tax on vastly unequal incomes, and watch the externalities shrink. Then we must ask the question “why” this is a viable solution. First, its purpose is to reduce inequality, not to make everyone pay a “fair share.” This goal cuts through the complaint that the rich are already paying far more than their share in taxes. Second, the tax should seek to change incentives. That is, its goal is to alter the pretax distribution of income, not just the after-tax distribution, to discourage people from seeking to earn exponentially more than their fellow citizens. With higher tax rates, a job in finance might lose some of its appeal to talented young people. CEOs might be happy with salaries averaging 20 times the typical worker’s earnings (the ratio in 1965) instead of 351 times the average, as was the case in 2007.

Finally, a tax on externalities is not designed to stop activity; a tax on pollution is not designed to eliminate industrial production, and a tax on inequality is not designed to equalize outcomes. It seeks only to reduce inequality from a level that threatens democracy to a level compatible with democracy, while still encouraging plenty of work and innovation. There would still be super-rich Americans, just not as many; some of them would be merely rich. And remember that after World War II top tax rates never dropped below 70% and the economy posted the strongest quarter-century of growth in its history. And we know that inequality increases when the top tax rates fall.

It might be argued that this only shows a correlation not causation; and that is possible. So, you might argue that high marginal tax rates are a threat to overall economic growth, but that argument doesn't hold up. There simply is no correlation; the economy grows more with higher marginal tax rates. How is this possible?

In every economy there are positive-sum games, in which market interactions benefit both parties, and zero-sum games, in which one party loses and the other wins. In a positive sum equation, we know the rich don't produce 351 times more widgets than the average worker. The answer is found in zero-sum activities, where the gains come at somebody else's loss. Zero-sum actions include increasing corporate earnings by holding down wages, taking advantage of financial customers by creating and gambling on complex or risky products that customers don’t understand, and lobbying Congress for protection from competition. As these examples suggest, some individuals in the top income group pursue quite a number of activities that others might be glad to see them spending less time on.

The lack of any limit to outsize economic rewards turns out to have a measurable cost, which Americans who aren’t so wealthy keep getting asked to pay. The way to change this is to recognize the externalities exist and to shift the incentives.

Yesterday we talked about the big settlement BP reached with the Department of Justice and the SEC over criminal charges related to the Deepwater Horizon oil rig explosion and spill of a couple years ago. One day later, and there is a new oil rig explosion in the Gulf of Mexico. It appears that 2 people are missing and 4 people have been evacuated; there were unconfirmed reports that 2 people died. The fire has been extinguished. The oil rig is run by a company called Black Elk. They've been fined for safety violations within the past year. The CEO of Black Elk used to work for BP.

JPMorgan and Credit Suisse have reached settlements with the SEC over civil charges that they fraudulently misled investors in residential mortgage backed securities. JPMorgan will pay $296 million, while Credit Suisse will pay $120 million. Both agreed to settle without admitting or denying the charges.

The SEC accused JPMorgan of making materially false and misleading statements about the quality of home loans that backed a $1.8 billion residential mortgage-backed securities (RMBS) offering it underwrote in December 2006. It also held JPMorgan responsible for the failure of Bear Stearns Cos, which the bank bought in 2008, to disclose its practice of keeping cash settlements from loan originators on problem loans that Bear sold into mortgage loan trusts.

Credit Suisse failed to disclose similar cash settlements, and also made misstatements in regulatory filings about when it would buy back mortgage loans when borrowers missed their first payments, known as first payment defaults.

Earlier this week, we learned the euro-zone has relapsed into double-dip recession as the austerity shock in the Mediterranean region spreads to the core countries of the north. The Club Med countries had a debilitating jolt of austerity without the juice of stimulus and the result has been contraction across the entire euro-zone. Unemployment across the EU has hit a record high 11.6%, and GDP has turned negative everywhere except Germany and France; give them time. I imagine Greenspan would find this acceptable, but its not real popular in Athens or Madrid. Even the International Monetary Fund looked at the past few years of harsh austerity and concluded that contractionary policies are contractionary

Palestinian missiles landed in areas around Jerusalem and Tel Aviv. Israel extended its bombing of the Gaza Strip and took steps to escalate. Israeli prime Minister Netanyahu is talking about calling up 75,000 reservists, which could signal a ground incursion into Gaza. About 550 rockets have been fired into Israel over the past two days, with 197 intercepted by their missile defense system. Israeli air strikes have hit more than 600 targets in Gaza. Israel’s air strikes have eliminated most of the long-range missiles in Gaza but there is still a threat. Israel said yesterday that it’s ready to step up its operation if rocket fire continues.

Maybe the Mayans were right.

Thursday, November 15, 2012 - Pick One or Pick All Four

Pick One or Pick All Four

by Sinclair Noe

DOW – 28 = 12,542
SPX – 2 = 1353
NAS – 9 = 2836
10 YR YLD =1.59%
OIL – 1.01 = 85.31
GOLD – 11.50 = 1717.10
SILV - .14 = 32.70

We had a few economic reports; they deserve mention; we also had a few flashpoints; we'll get to those soon.

Consumers paid somewhat higher prices for food, rent and housing in October, offsetting a decline in the price of gasoline at the pump. The consumer-price index edged up a seasonally adjusted 0.1% last month. Inflation-adjusted hourly wages, meanwhile, fell by 0.2% in October. Wages fell slightly, even as consumer prices rose, to account for the decline. Real wages have fallen 0.7% over the past 12 months, meaning consumers have less buying power compared with one year ago. Consumers got some relief in October, however, from the falling price of gasoline. The government’s price index of gas, which spiked 16.6% from July to September, tapered off 0.6% last month. The more important number to consumers — the actual cost of a gallon of gas — fell by almost 7% in October and retail prices continued to decline in the first two weeks of November. The average national cost is about $3.50 a gallon, down from nearly $4 a few months ago.

Hurricane Sandy contributed to negative readings for both Philadelphia- and New York-area manufacturing gauges in November; not a surprise.

First-time jobless claims soared by 78,000 to a seasonally adjusted 439,000 in the week ended Nov. 10; its the highest level for initial claims in 18 months; largely a side-effect of Hurricane Sandy.The bottom line is that in coming weeks the data will be extremely volatile and will likely not reflect the true picture of the labor market developments.

Tens of thousands of European workers take to the streets in a historic, concerted action to protest soaring unemployment and unprecedented austerity. The Bank of England's Mervyn King warns that the slump will be longer and more painful than imagined. It is slowly dawning on policy-makers in each region just what a mess they are in. Mervyn King warns that, five years after the collapse of Northern Rock,the British economy is still only halfway through the crisis. Meanwhile German Chancellor Angela Merkel talks of another half a decade of misery in the euro-zone.

The European Union statistics agency, Eurostat reports third-quarter euro-zone gross domestic product shrank 0.1% compared to the second quarter. That’s equal to an annualized contraction of around 0.4%. That follows a 0.2% quarterly contraction in the previous three months. A recession is widely defined as two consecutive quarters of shrinking GDP. The figures didn’t tell us anything we didn’t already know. However, they did confirm that things are at least as bad as we thought.

Greece's finance minister has written to the UK's finance minister asking for further information on Greek citizens who were recently revealed to hold offshore accounts with HSBC in the channel isle of Jersey.

"We had no idea about their existence and were surprised when their names were included on the list recently made public by HSBC," said a senior finance ministry official. "The minister sent the letter because he wants to get to the bottom of it. Tax evasion is one of our biggest problems."

An estimated 57,000 Greeks are believed to have transferred banks deposits abroad since the crisis' outbreak in Athens in late 2009.

In a separate development, the finance minister announced that the country was also poised to dispatch letters to some 15,000 Greeks who moved about €5bn abroad without declaring it to tax authorities. "More than €2bn of that amount could be recouped in taxes," said the finance ministry official. "Ordinary Greeks who are suffering from so much austerity want to see some action."

The International Monetary Fund drew a line in the sand on Greek debt negotiations today, saying the fund’s European bailout partners must do more to cut the ailing country’s debt for the sake of the global economy and the fund itself can’t offer any better loan terms. German chancellor Angela Merkel has once again rejected the idea that governments should take a loss on their loans to Greece.

There is still a lot of talk about the fiscal cliff. Nothing much changed today. We'll keep you posted. Federal Reserve Bank of Dallas President Richard Fisher said: “Only the Congress of the United States can now save us from fiscal perdition. The Federal Reserve cannot,” and he added the Federal Reserve won’t be there to bail out legislators if they fail. Fisher said: “Our Congress–past and present–has behaved disgracefully in discharging its fiscal duty.” Apparently Fisher missed the irony of his remark. Also, no notice of how similar Fisher's remarks sound to the IMF's warnings on Greek debt negotiations.

 Federal Reserve Chairman Ben Bernanke said today that banks' overly tight lending standards may be holding back the U.S. economy by preventing creditworthy borrowers from buying homes. 

Bernanke said: Some tightening of credit standards was needed after the 2008 financial crisis, but "the pendulum has swung too far the other way." Qualified borrowers are being prevented from getting home loans. Well, we know he's aware of the problem, the question is what will he do about it. In his speech, Bernanke gave no hint of what future moves the Fed might take. But he said officials at the central bank understood the problems still facing the US economy. Bernanke said the housing has shown signs of recovery this year. But he said construction activity, sales and prices remain much lower than they were before the crisis. About 20 percent of mortgage borrowers remain underwater.

Oh yeah, the Israelis and Palestinians are throwing bombs at each other across the Gaza border.

Fiscal Cliff, European recession, War in the Middle East, weak economic numbers in the US – Four flashpoints; pick one or pick all 4, and the world did not explode. It's a good day. 

BP has agreed to pay the largest criminal fine in US history – $4.5bn – to resolve all criminal charges arising from the fatal explosion and oil spill in the Gulf of Mexico.

BP agreed to pay $4bn to the US government over five years, and $525m to the Securities and Exchange Commission. That money will be paid over three years. The criminal settlement does not settle all of the claims against BP for the April 2010 blowout of the Deepwater Horizon, and the subsequent oil spill.

BP is not yet off the hook for environmental damage to the Gulf of Mexico, and could face billions in restoration costs to waters, coastline and marine life. The deal does limit BP's exposure to further criminal charges and penalties, and frees the company to focus on resolving those other civil claims.

The fine is the largest criminal penalty in US history, easily outstripping the previous record of $1.2 billion levied by the Justice Department against Pfizer over fraudulent marketing practices. In addition to the fines, the oil company agreed to plead guilty to 11 felony counts of misconduct or neglect of ships' officers, arising from the deaths aboard the Deepwater Horizon when the rig exploded and sank. It also agreed to single misdemeanour counts under the Clean Water Act and the Migratory Bird Act and one felony count of obstruction of Congress.

The settlement remains subject to US federal court approval.

Two BP employees will also face manslaughter charges over the 11 deaths in the oil-rig explosion that triggered the spill.

Notice that BP will not face charges of manslaughter, two employees will. Another reason why corporations are not people.

The US Census Bureau has released its report on “Income, Poverty, and Health Coverage in the United States:2011” Median household income declined, the poverty rate was not statistically different from the previous year and the percentage of people without health insurance coverage decreased. 

Real median household income in the United States in 2011 was $50,054, a 1.5 percent decline from the 2010 median and the second consecutive annual drop.

The nation's official poverty rate in 2011 was 15.0 percent, with 46.2 million people in poverty. After three consecutive years of increases, neither the poverty rate nor the number of people in poverty were statistically different from the 2010 estimates.

The number of people without health insurance coverage declined from 50.0 million in 2010 to 48.6 million in 2011, as did the percentage without coverage - from 16.3 percent in 2010 to 15.7 percent in 2011.

In 2011, the median earnings of women who worked full time, year-round ($37,118) was 77 percent of that for men working full time, year-round ($48,202) ─ not statistically different from the 2010 ratio. Real median earnings of both men and women who worked full time, year-round declined by 2.5 percent between 2010 and 2011. The rates of decline for men and women were not statistically different from one another.

Based on the Gini index, income inequality increased by 1.6 percent between 2010 and 2011; this represents the first time the Gini index has shown an annual increase since 1993, the earliest year available for comparable measures of income inequality. The Gini index was 0.477 in 2011. (The Gini index is a measure of household income inequality; zero represents perfect income equality and 1 perfect inequality.)

Income inequality also increased between 2010 and 2011 when measured by shares of aggregate household income received by quintiles. The aggregate share of income declined for the middle and fourth quintiles. The share of aggregate income increased 1.6 percent for the highest quintile and within the highest quintile, the share of aggregate income for the top 5 percent increased 4.9 percent. The changes in the shares of aggregate income for the lowest two quintiles were not statistically significant.

In 2011, 13.7 percent of people 18 to 64 (26.5 million) were in poverty compared with 8.7 percent of people 65 and older (3.6 million) and 21.9 percent of children under 18.