Sunday, November 28, 2010

Economy & Market Week Ended 11/19/2010

The problems of the euro nations as magnified in Ireland have created a whirlwind of concern and doubts among international investors increasing debt costs, bank access to liquidity lending, withdrawal of corporate (foreign?) deposits in Ireland, and currency crisis pressure on the euro.  The amount of research available is almost overwhelming and much will have to be overlooked given time constraints.  As you do go through the overview we are providing, please understand that I use the links in paragraphs to provide substantive information which should not be skipped.

Over a week ago in the week ending 11/19/2010, Ireland, the ECB, EU, and IMF were going back and forth and the rumors were flying with Ireland denying bailout talks and the ECB and IMF supposedly demanding bailout for Ireland.  What the focus on Ireland has done is more brightly expose the problems of the European Monetary Union  and its failure to construct a fiscal union, of which Munchau wrote during the week, structure which would allow it to respond to the particular fiscal needs of its individual sovereign nation members and how this is creating a growing, and potentially, cascading currency crisis which is reflected not only in debt and swap prices but in the declining value of the euro.  While the banks in Ireland created, with the help of foreign investment,  serious financial problems through the profitable misallocation of resources until the mismanagement and/or fraud caught up to them in the financial crisis of 2008 and the debts and losses of the banks suddenly became those of the common citizenry rather than the bankers and senior bond holders who want the profits and not the losses.  Then, having taken on the private bank debts and guaranteeing the senior bond holders and earning accolades for its austerity program, the government of Ireland met the inevitable in reduced revenue and less economic growth aggravated by austerity programs and bank toxic assets worth far less than estimated rolling around in an ill conceived bad bank, which made government issued bonds a problem for the ECB, and nationalized framework compounded by growing loss of faith by foreign investors.  Rather than focusing on the banks and their financial participants, the people of Ireland are being told they have too much debt and its their fault the government budget has a growing deficit gap.  While the government has made political spending mistakes and cultivated some inefficient policies, the primary cause of their present dilemma is private bank debt assumed as public debt as the Irish government curried favor with the European Union and the European banks who are among the senior bond holders of the Irish banks.

The bailout debate revolved around whether the bailout would provide funding for Irish banks only or the sovereign government of Ireland or both.  The formal process of bailout application and consideration was much touted but pushed aside as the IMF, ECB, and EMU sought a forced bailout to stem the loss of faith in eurozone debt and failure of fiscal policy response within the eurozone as the result of how the euro was created as well as concern the EMU emergency funding mechanism (ESFS) has not been funded.  The bailout figures were rumored to be 80 billion to 140 billion euro with EU "partner" enthusiasts voicing approval of a bailout which would provide support and those who saw a bailout as the only hope for an austerity deprived country without its own currency, weak banks with liquidity problems, rising debt costs, and only limited authority to exercise normal fiscal policy.  While members of the Irish government kept insisting Ireland is well funded and does not need a bailout, the Governor of the Irish central bank was publicly adamant there was no choice.  Given the ruling political party has been in charge during the growth of bank financial abuse and mismanagement prior to the 2008 financial crisis and readily assumed the bank's private debt as public debt, the current political situation appears to be leading to new parliamentary elections.  Many are pointing out that Ireland is not Greece and it may have the economic strength to default, withdraw from the euro, give bank equity, through the issuance of contingent convertible bonds or the use of debt as legal tender, for bank debt (bondholders), or form a monetary union, as Samuel Brittan has in "Conventional Wisdom, the Royals, and the Republic", with the United Kingdom.  Attempts to get Ireland to raise its corporate tax, even though it is not substantially different from other corporate tax rates in Europe, have been seen as yet another attempt to destroy Irish independence.  Much of this anger has been directed at Germany which continues to insist that future bailouts must include bondholders sharing in the losses, which is not an unreasonable request except that, at this particular point in time, it is increasing international doubt about the euro and encouraging increases in debt costs.  Given the exposure of German banks to Irish private and bank debt, Germany's insistence on bondholders sharing in the losses, while politically popular in Germany, is counter productive to Germany's own economic stability, which it clearly understands would not be served well by failure to support Ireland.  If this credit crisis is allowed to fester and move from country to country on growing doubts the European Monetary Union will continue to refuse to allow the currency to support appropriate fiscal policy, it will spread beyond Portugal to Spain, Italy, Belgium, and even Germany as the costs mount towards 1650 billion euro of untimely and austere responses.  If the eurozone were to act with any reasonable degree of fiscal unity, or even just move towards a mechanism of fiscal unity involving support of fiscal policy relevant to each individual sovereign member ( some people might call these fiscal stabilizers), the demonstration of compromise and a common benefit would do more to stabilize international doubts than bailout after bailout.

While the European Council has agreed to consider a sovereign debt default mechanism, but the politics of its construction may very well make the eurozone more fragile, much like the failed Exchange Rate Mechanism and its incentives for speculation, by an acceptance of continuing financial crisis.  It has also accented the possibility of default and bond haircuts at a time of current interest rate pressure on debt.  A monetary union requires fiscal assistance between its members rather than a reliance on moral hazard, in which the inconsistencies of the European Monetary Union are excused in the name of debt vigilantism austerity and the necessity to protect banks at the expense of the people.  Despite Ireland's insistence it is well funded into 2011, the banks in Ireland have seriously limited access to interbank lending internationally; this has aggravated the Irish banks long term liquidity in a threat from bank funding constraints.

Yet, the financial forces in Europe and the world are insistent it would be preferable to have sovereign default in which private bank debt has been made public debt rather than banks failing and bankers losing money.  On the one hand Germany is pushing for a sovereign default mechanism and bondholders sharing in the losses as if Germany does not have a clue that German banks followed by UK banks have the most exposure to Irish bank and private debt.  Germany's leadership is bringing the question of whether the euro can survive into ever more contention and that contention is costing other euro nations more and more in debt costs.  In the meantime, the myth of German prosperity under austerity belies the large fiscal stimulus program which buffered Germany in the 2008 financial crisis.  Of more concern is the refusal of German politicians to acknowledge the success of their fiscal stimulus program and continue to assert austerity as the only economic path.  Germany is headed back to a record current account surplus despite its captive eurozone market countries debt problems, which have been partially caused by the different exchange rates and the effect of those rates over the years to create seriously out of balance current accounts within the single currency eurozone.  This can bee seen most clearly in Greece, in which the loss of competitiveness as the result of these current account imbalances and exchange rate dynamics, may demand Germany extend its credit to Greece in order to stimulate the divergence in the cost of capital with the emergence of counterparty risk.

As the austerity infection multiplies worldwide, the United States is proving itself an increasingly willing victim as politicians avoid getting things done, such as creating jobs and reducing excessively high unemployment and creating regulations which will make bankers responsible for systemically dangerous, however profitable, business conduct, as it is easier to join the crowd which proclaims the bailout of banks as enlightenment and the very fault of the people upon whose backs the cost of the bank bailouts is being foisted as shared sacrifice; people who obviously cannot properly manage the debts placed on their backs by bailouts as well as the banks can shift their losses to the people and become larger and more powerful.  There are those who would rewrite history, and President Obama has fallen into this trap, and insist President Franklin Roosevelt did not take action until riots forced his hand in 1934 which is patently false.  Unlike President Obama, President Roosevelt was not persuaded by the financial interests and outgoing President Hoover to reaffirm the status quo commitments to a gold standard, support of the private banks, and austerity.  With the recent report of the Deficit Commission, which reads like a litany of its members vested interests and historical prejudices, the economic debate may be pushed back even further from public debate as blame is transferred from bankers and financial traders to the irresponsible people and any government which provides programs to serve people.  As this report is analyzed going forward, it is obvious that it just places more of the burden on the backs of the citizenry, even proposing a national sales tax., and the diminishment of that troublesome middle class.  But when it comes to tax breaks for the wealthy, the economic cost to government is thrown out the window as we have demonstrated in past articles with false arguments that such tax breaks will stimulate the broader economy.  President Obama appears willing to cave, yet again, to the financial elite.

The mortgage mess continues despite financial institutions attempts to throw the problem back onto the victims of the fraud who are just trying, in the version put forth by the banks and mortgage servicers, to put off foreclosures resulting from their deadbeat life styles.  The problem with these fraudulent documents is not just a subversion of contract law and due process but the possible risk of billions of dollars in losses, as we have reported previously.  The Congressional Oversight Panel has issued a new report on the mortgage processing problems with detailed analysis of different scenarios depending on the depth of the legal problems involved.  Congressional hearings have not gone well for the bankers and the mortgage servicers.  But public hearings do not always translate into real governmental action as the public performance is always easier than the delivery of service to the public good.  Already a backdoor attempt is being made to retroactively make the whole mortgage processing mess and lack of legal documentation legitimate, although many financial bloggers have sniffed it out and raised the hue and cry of the hunt, despite PR attempts to dress the proposed legislation as just a modernization of the Interstate Commerce laws.  Still the lobbyist and lawyers are hard at work to build a see no evil, hear no evil, speak no evil defense.

Federal Reserve Chairman, Bernanke, gave two speeches in Europe: one on "Rebalancing the Global Recovery" and the other on "Emerging from the Crisis: Where do We Stand?" in which he recognized the need for fiscal stimulus (by government) to impact high unemployment to enhance long term growth, criticized China for its undervalued currency and use of capital controls noting the long term effects on the world economy are negative, and noted slower expansion in the United States, declining inflation, and continued high employment while defending QE2.  With China's internal concerns with rising inflation and lending bubbles, it is unlikely they will do more than allow the renminbi to slowly appreciate within a trading range as they adjust the middle point slowly up and will concentrate on interest rates, price controls, and industrial production for internal consumption.  Many view the Chinese monetary policies and the Fed's QE2 as both promoting inflation in other countries and as self-serving exchange rates in trade, defacto devaluation, and favored monetary credit position.  The G20 meeting did nothing to defuse the confused global monetary systems and exchange problems flirting with currency trade wars, despite the growing awareness that what we have now does not work and will be replaced one way or another.  The political scare mongering in the United States that QE2 will cause inflation is so hyper unrealistic as to deny the factual reality of the economic data.  I have been very vocal that QE2 will have little effect on the economy and will primarily benefit bank liquidity as the banks continue to build cash reserves.  The political attacks on the Fed and QE2 have gone beyond monetary policy debate and have become a construction project in which the mess created by the banks and their political supporters is being excavated and transported to the door step of the Fed alone rather than taken to Wall Street and Washington, D.C. where the dirt belongs.  QE2 is a basic acknowledgment that the yield curve on short term Treasuries had no room for movement and lowering the rates of longer term Treasuries, through Fed purchase on the secondary market, might spur new investment and consumption.  The thinking is correct, but the situation is such that the consumers pocket is under pressure and corporations only spend money to make money and if not enough people are buying than no one is going to be spending as much as the economy needs to revive itself from this most recent sacking by the financial vandals who grow fatter as their failures are are sugar coated with profitable bailouts.

More analysts are predicting a Chinese real estate supply shock within a year which might destabilize prices short term but this could be seriously aggravated by how the inventory wave comes to the market, i.e., how fast and how large.  China has been tightening interest rates, lending policies, and increasing down payments.  China is fully aware that this potential real estate bubble exists and must be controlled as we have written in the past.

Michael Pettis wrote an interesting analysis of the need for China's growth to slow and what the effect of that slowing down will have on the world economy and to China internally in which he took exception to the commonly voiced concerns that a Chinese slowly would mean a sharp downturn in global growth and cause social and political instability within China, because he believes the impacts will be very dependent on how China actually rebalances.  He uses the Japanese slowdown, which began in 1990, as a detailed example of what might happen in China.

Eggertsson and Krugman wrote an economics paper on Debt and Deleveraging which attracted vast attention for an economics paper which created a model and economic logic in which a temporary deficit is shown to be necessary and beneficial during a balance sheet recession.  Like all model and economic logic constructs it includes assumptions which are worth investigating and has caused much comment.

John Hussman in his November 15th commentary again stressed the need to evaluate the market with in the full context of conditions and indicators as well as the historical relationship between current high profit margins and poor earnings growth going forward over five year periods. The failure to adjust richly valued stocks with high P/E multiples for the level of profit margins ignores the measures of sustainable, long term, full cycle financial performance.  He is concerned that the "economic recovery" with high unemployment and stagnant personal income with huge amounts of debt hidden under rugs and dressed up for balance sheets is illusory and festering until it reignites.  He believes the only way to deal with a major debt crisis is through debt/equity swaps, restructuring, and writedowns.  His example is the failure to resolve the mortgage problems equitably for both lender and borrower.  He wants to see swaps of principal for pooled property appreciation right administered, but not subsidized, by Treasury.  "...until our policy makers wake up to the need to restructure debt, so that the obligation is modified for both the debtor and the creditor ... we are racing toward the financial equivalent of a mathematical singularity, where the quantities become so large and the outcomes become so sensitive to small changes that the whole system becomes unstable."  He finds the market climate for both stocks and bonds to have become unfavorable.

Market: 3 banks failed = 149; unofficial problem bank list = 903

                           Dow/Volume                                             Nasdaq/Volume
Mon:           9.39/down 13.1%                                     <4.39>/down 16.1%
Tue:      <178.47>/up 51.9% market in correction  <43.98>/up 21.2%
Wed:           <15.69>/down 28.5%                          6.17/down 18.8%
Thu:             173.35/up 27.2%                                        38.39/up 12.6%
Fri:                22.32/down 9.1%                                       3.72/down 10.0%

Total                  10.90                                                               <.09>

Mon: Oil down 2 cents to $84.86; Dollar stronger; day ended flat after being up most of the day; retail sales were up moderately but the New York Fed Empire State Index (manufacturing) was surprisingly down; Ireland and EU in talks despite Ireland's denial of bailout need.

Tue: Oil down 2.52 to 82.34; Dollar stronger; European "debt" problems and Ireland resisting aid; Chinese expected to place inflation curbs on food, etc by end of week.

Wed: Oil down 1.90 to 80.44; Dollar weaker; lower volume rally ends slightly down and mixed; oil supplies were down 7.3 million barrels, gas supplies were down 2.7 million barrels, and distillate was down 1.1 million barrels.

Thu: Oil up 1.41 to 81.85; Dollar weaker but stronger against the yen; GM IPO surges world markets but ends day at lower end of GM trading range; Ireland assistance expected; weekly jobless claims were up 2000 to 439,000, 4 week moving average was down 4000 to 443,000, and continuing claims were down 48,000 to 4,295,000.

Fri: Oil down 34 cents to 81.51; Dollar stronger but weaker against euro; very low trading for an options expiration day.

United States:
The Consumer Price Index for October was up .2 for an annualized 1.2% rounded.  Core CPI for October was zero with an annualized rate of .6, which is the smallest 12 months in the history of the index which dates to 1957.  If the 1980's calculation for CPI was used the annualized rate would be approximately 8.3%; if the 1990's calculation was used the annualized rate would be approximately 4.4%.

The ECRI Weekly Leading Index is up to <4.5> from <5.5> and, just as last week, this is the highest in 5 weeks.

We have repeatedly emphasized the large contribution of inventory rebuilding in the growth of GDP in recent quarters.  Given the build up over those quarters and the $110 billion inventory increase in Q3, it is possible that Q4 GDP will see a negative impact even if there is a strong inventory increase but substantially less than Q3.  With the mismatch between new orders and inventory levels, it is conceivable growth will be negatively impacted in coming quarters.  Despite other indicators, the mathematics of inventories could expose a recession.

California intends to restructure the sell of $`14 billion in bonds in the face of a sell off in the municipal bond market.  California will sell $10 billion in revenue anticipation bonds due May and June, then $2 billion in Build America Bonds, and then $1.75 billion in tax exempt bonds.

30 year AAA muni bonds rose 15 bps points in the week ended 11/12; largest increase in 18 months.

Goldman Sach's plan to repay Berkshire Hathaway has been delayed as the Fed reviews the process for setting a dividend increase policy for banks.  By Wednesday, the Fed announced it would examine large bank holding company's ability to absorb losses and meet new capital requirements under Basel III when deciding whether banks may increase dividends or buy back shares.

The government amended the regulation on grandfathered status under the health law to allow group health plans to switch health insurers providing similar coverage at a lower cost without losing their grandfathered status.

U. S. retail sales in October were up 1.2%.

New York Fed Empire State Index (manufacturing activity) was down to 11.7 from 15.7 --- unexpected --- for first time in more than a year; new orders were down to <24.4> from 12.9; inventory was up to zero from <11.7.

U.S. business inventory was the highest since October 2008 up .9% to $1.4 trillion; sales were up .5%; inventory to sales ratio was unchanged at 1.27 months.

EMC will buy Isilon for $2.25 billion; Caterpillar will buy Bucyrus for $8.6 billion.  Is this a wise use of cash?  When companies buy another company, are they investing for synergistic growth or are they using idle cash not worth using to increase sales?

BHP is abandoning its Potash bid and will do a $4.2 billion stock buy back.  This is another possible misuse of idle cash depending on the fair value of the company's stock making the buy back.

Lowe's sales missed analyst's expectations with Q3 earnings of $404 million or 29 cents per share; sales were up 1.9% to $11.59 million (expected $11.75 million) and up .2% same store.

Home Depot beat Q3 EPS estimates on tighter cost controls, but softened its full year sales forecast; net income was $834 million or 51 cents per share; sales were up 1.4%.

Wal-Mart Q3 earnings were 95 cents per share (expected 90 cents) up from 82 cents a year ago; sales were up 2.6% vs year ago (below expectations); U.S. same store, ex fuel sales, were down .7%.

CapitalOne credit card charge offs in October were to to 7.26% from 8.38%; 30 day delinquencies were down to 4.45% from 4.53%.

Lacker (Richmond Fed) said the Fed's new monetary easing is potentially dangerous and likely to be ineffective.  "Trying to keep unemployment lower than it otherwise would be is a recipe for continually accelerating inflation."  He does not believe Fed QE2 is designed to weaken the dollar and is not currency manipulation.

Dudley (New York Fed) said QE is not aimed at weakening the dollar; the Fed has no dollar value level target; it is just trying to ease financial conditions.  QE2 will not have a powerful effect on the U.S. economy, but even a little nudge will help according to Dudley.  He said the Fed is trying to avoid a "stall speed for the economy".  He rejected the idea the Fed should target a higher inflation rate.

GM raised the price range of its IPO to $32-33.  We have already written that it is oversubscribed and not offered through several discount brokerages, which means individual investors will have a very difficult time buying and that may be just as well.  It might be better to see how it is trading six months after the IPO.

Paulson & Co. hedge fund sold 100% of its Goldman Sachs holdings, 18% of its bank of America shares, 16% of Citi, and 11% of Wells Fargo as the result of regulatory changes and the mortgage mess.

FHA auditors said its capital reserve ratio was down from .53 to .50 primarily as the result of more conservative assumptions of future housing values.

PPI (Producer Price Index) wholesale prices were up .4% (expected up .8%) and core PPI was down .6% (expected up .1%).  These were considered deflationary.

Federal Reserve reported October capital utilization was flat at 74.8 with industrial production unchanged at 74.6.

Senator Corker wants the Fed to forget about price stability and full employment and focus on inflation, which is price stability.

Bank of America was ordered to $500 million of deposits seized from Lehman.

Bullard (St. Louis Fed) said that "to extent possible" the U. S. needs to let the private sector provide the bulk of U.S. housing financing and he wants lower income financing support separated.

Rosegren (Boston Fed) said U.S. needs short term fiscal stimulus to boost jobs and complement the Fed's moves.  He said that without QE2, there was a risk of further disinflation.

CoreLogic reported housing prices in September (3 month average) was down 1.8%.  According to the Census Bureau, housing starts were down 11.7% in October from September, which is an 18 month low.

Foreign ownership of U. S. Treasuries was up $39.5 billion in September; China's purchases were up 1.7% to $883.5 billion in the third monthly increase.

19 banks will have new stress test by the Fed in early 2011.

The FDIC is probing at least fifty cases of possible fraud and other criminal conduct at failed banks.

Mortgage applications were down 14.4% the week ended 11/12 to a four month low; 30 year mortgage was up 18 bps to 4.46%, which is a two month high.

Two million people will lose unemployment benefits by the end of December if Congress does not renew extended benefits.

Bank of America modified 52% more mortgages in October than September.

Philadelphia Fed business activity index was up to 22.5 November from 1.0 October --- the highest since last December --- and new orders were up to 10.4 from <5.0>; inventory was down to <18.6> from <5.9>.  This is in direct contrast to the New York Empire State Index.

S&P 500 earnings since Q1 2009 low have increased over 900% (see the Hussman commentary above) to just over the level at the peak of the last dot com bubble.

SEC will consider a proposal to require registration of advisers to hedge and private equity funds with more than $150 million in assets under management.  With the CFTC, they are working out the details of what and how swap trade data will collected and stored.

Mortgage delinquency rate was down .72% Q3 to 9.13%; the foreclosure pipeline was down .18% to 4.39%.

U.S. has found 13 million metric tons of rare earth deposits.

After the market closed Friday, Green Mountain Coffee said it will restate its financial statements for the last 4 years to correct reporting errors.

Fuel prices are expected to be the highest in 3 years this Thanksgiving despite oil prices dropping.  Fuel prices are expected to fall after the Holiday.

United Kingdom inflation was up to 3.2% October on increased taxes, fuel, bank/mortgage fees, and computer games.  Core was unchanged at 2.7%.  Next Plc, the second largest clothing retailer, indicated prices are going up approximately 8%.

There is originator support of structured finance deals in Spain which are enabling the banks to maintain collateral eligibility for repo with the ECB.

Benedicto Marzinotto argues that the G20 definition of the 27 member EU as a single region, including the eurozone, makes the trade imbalance seem better than it really is for the member nations.  She also argues that the EU commission's position that trade imbalance are the result of competitiveness issues and can be controlled by wages and prices and exports ignores much more complicated nation by nation problems.

Austria is insisting Greece has not met its commitments and Austria is refusing to release its contributions to the Greek bailout.

Goldman Sach's has a sixteen page analysis of Ireland which sees more upside than downside.  By the end of the week much was being made about the corporate account withdrawals (foreign?) from Irish banks, which was being hyper characterized as a "bank run" when there is no evidence domestic demand deposits are being withdrawn, and about the contradictions and counter productive actions and policies within the EU and eurozone.

Japanese GDP Q3 was 3.9% annualized, but Rebecca Wilder says it is not sustainable and has a decent chance of turning negative in Q4 2010.  On a side note, Rebecca Wilder subsequently announced she will not be blogging any longer due to work and family commitments, her intelligent observations will be missed and hopefully she will post from time to time.  She is a very intelligent economist and any objection or question I may have had in the past about the use of a term is to me a normal part of educational discussion and debate.

German Landesbanken (savings banks) have refused German government offers of recapitalization and have only until year end when the offer terminates.

Bank of Korea raised its 7 day repurchase by 25 bps to 2.5% to curb inflation.

Spain Q3 GDP was flat to Q2 as the result of austerity cuts.

Strauss-Kahn (IMF) said Germany's recovery will not last long if conditions do not improve elsewhere.

Singapore GDP was 10.6% Q3, but expects it will slow sharply next year with lower U.S. and European demand.

The OECD expects 2.8% growth for its 33 member nations (4.6% for the world) as households and firms reduce debt.

South Korea is considering a tax on foreign investment in its government bonds.

Spain sold 3.6 billion euro of 10 year and 30 year bonds, both of which were up 50 bps in yield.  This auction was essentially a positive investor response.

China, for the second time in two weeks, ordered bank reserves raised 50 bps to 18.5% to strengthen liquidity management as they continue to manage price pressures cautiously. The frequency of these announcements spooked the market which went down as did the price of oil.

The OECD expects Germany's current account balance surplus will back to 7.2% by 2012, which would be close to the record 7.6% in 2007, and sees Germany going back to the same pre-crisis pattern.

Allied Irish Bank says customers, but made no attempt to specify what kind of customers, have pulled 13 billion euro this year and mortgage problems worsened in Q3.

Samuel Brittan suggested Ireland withdraw from the euro and form a monetary union with the United Kingdom.  Gavyn Davies wrote of the need for Europe to compromise if financial crisis and the fiscal problems of the eurozone are to be solved. Wolfgang Munchau wrote of the failure of the eurozone to structure a fiscal union, which is a problem I have also written about on more than one occasion.  All of these were linked in the Irish paragraphs at the beginning of this article, but I am repeating them here because they are important.

Strauss-Kahn of the IMF said, "Europe needs a holistic growth strategy. where every country benefits from the efforts of all others."

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