Wednesday, December 22, 2010

Economy & Market Week Ended 12/11/2010

As we wrote in "Political Economics vs Political Compromise", which was our analysis of the new tax cut law which passed on the 17th of December, it was very disappointing to have the President of the United States publicly demonstrate that he does not know the history of the beginning of Social Security.  Social Security is easy to class warfare criticize if you do not need it, but the real problem is the insurance and medical provider fraud in Medicare and the increasing costs that fraud causes.  We have a President who promised change and has delivered a style of compromise which has failed to deliver opening the door to economic stagnation, a further institutionalization of inequality, and left a vacuum being filled by the political instability of discontent.

Consumer credit rebounded off its 2009 lows, but a closer inspection shows an increase of student loan debt has increased 80% vs year ago expanding $120 billion as the result of the Department of Education stepping in and buying privately originated student loans meant to be securitized but which could not be marketed starting in 2008 when the credit market dried up.  Since then, this program has been expanded and may be totally distorting consumer credit in 2010.

The Cleveland Federal Reserve, in a report, visually shows the meaning of a "Jobless Recovery" after an 18 month Recession, which average 10 months historically, in which payroll employment is still 5.4 points below the pre-Recession peak after 35 months (usually takes 23 months) and only adding a average of 86,000 jobs per month since the beginning of 2010.  In fact, the recession and continued high unemployment have had a tremendous negative impact on American families and households in which 39% of American households have been either unemployed, had negative equity in their home, or been arrears in house payments.  Of long term concern is the 10% drop in employment among young workers, particularly recent college graduates facing years of lost income and lower future earnings.

Bill Mitchell took an in-depth look at Australian employment/unemployment figures for the month of  November in which there was noticeable improvement but with significant remaining slack.  One area of Bill Mitchell's economic concentration is employment and his observations of Australian employment and governmental policies with its aging population, of increasing underemployment among 15-24 year olds, of growing part-time employment, and of higher overall underemployment than the severe 1984 recession are relevant to the United States and many other developed countries with an aging population..

The sell off of 10 year U.S. Treasuries with yield rising to 3.3% by the 8th of December has been accompanied by increasing yields of other nation's bonds globally including the German bund.  There may be market fear that future  bond losses will neutralize QE2 and lead to stagflation.  As of the 11th, three German bond auctions have failed.  Many saw the German bond, which has been treated as a safe haven, auction failure as reason to question the U.S. Treasury auction when the bonds are not comparable.  Germany does not have its own currency and is fiscally constrained and the United States fiat currency is a global reserve currency, making United States debt desirable.

As we have repeatedly reported, the comparison of U.S. states to the eurozone sovereign member nations is not legitimate.  However, it continues to be used by deficit hawks.  The portrayal of the Build America Bonds as a failed jobs program miring the states in debt is wrong; it was (it is being allowed to expire) a program which opened municipal bond market participation and targeted a decaying infrastructure.  It was investment and economic recovery is always dependent on investment.  Investment in the short term leads to deficit and debt reduction long term not the other way around.  Investment leads to an increase in aggregate demand through infrastructure, research, and defense government investment spending.  Those hoping and pushing for large deficit reductions will be disappointed by the resulting decline in tax revenues and increasing unemployment with demands for increased jobless benefits and increased taxes.  A more efficient and fair tax system would efficiently reduce a deficit, but it would not benefit the corporate and monied interests, who benefit from the current corporate welfare programs, financing the deficit hawk politicians.

The Deficit Commission proposals, which will not receive enough Commission votes to be recommended, are ill conceived and antithetical to the free market principles of Adam Smith.  The proposals would continue to promote financial bubbles and competitive inequality.  The present Tax Cut proposed law (since passed) runs the risk of not serving public needs but rather supporting the ability of private oligopolies to dominate state policy making against the interests of the people.  Investment, targeted efficient expenditures, and a return to full employment are the quickest ways to economic recovery and deficit and debt reduction.

An IMF working paper entitled "Inequality, Leverage, and Crises" has been creating quite a stir in economic circles with its analysis of a comparative growth of income and wealth inequality in the years preceding both the Great Depression and this most recent financial crisis directly contributed to causing both economic crises. Consumption inequality increased the need for financial services.  With the growth of the financial sector with wealthy saving, leverage increased without prospect of recovery of household incomes and the bargaining power of lower and middle class were limited decreasing demand and increasing household default.  Economists are amazed that a paper on income and wealth inequality showing the importance of household  bargaining power as necessary for increased demand and growth is coming from the IMF.  I was more impressed with the study of leverage and income inequality, because they seem to have a direct relationship with financial bubbles and crises which in effect concentrate more power in the financial elite and diminish the power and numbers of the middle class.  Without a strong middle class a republican democracy is not sustainable.

Along the same lines a new NBER paper, "Financial Crises, Credit Booms, and External Imbalances: 140 Years of Lessons", shows credit growth (leverage) -- not current account balances -- generates the best predictive signals of impending financial instability.

A broad review of prices shows significant disinflationary trends and why the Fed is worried about deflation.  Over a sixth of consumer spending is on goods and services for which the prices are falling and three-fourths on goods and services for which prices have slowed.  A relatively high level of these disinflationary trends is located in goods and services which make up core inflation.  Deflationary and disinflationary pressures are relatively large in historical terms.

The U.S. Treasury Department solicited an legal opinion it had no legal need to request to lend credence to the position of the Treasury Department that it did not want to (and will not) use TARP funds to help borrowers facing foreclosure despite having the "extraordinary" power within TARP to do whatever is necessary to protect housing values, home ownership, and economic growth.  Evidently, it is more important to protect banks than home owners during depressed prices.  The banks foreclosure mess and frauds have revealed just how financially vulnerable the banks really are and they are using that weakness to blackmail and co-opt the government into looking the other way.  To further silence critics and advocates of due process, lawsuits are being filed against foreclosure defense attorneys to exhaust their time and money.  Reports of threats on attorneys and their families are also circulating.

An MBIA lawsuit against Morgan Stanley and its mortgage servicer over a group of second liens which were rate AAA it insured and for which MBIA has already paid $70 million in claims.  What is interesting about this lawsuit is a further claim that Morgan Stanley's servicers has failed to charge off these second liens after 180 days as required by the servicing agreement.  Banks do not want to charge off loan assets and reduce their capital ratio as is witnessed by other reports that banks are holding foreclosed homes on their books at full price rather than sell them for less and not taking any action of any kind against high income home owners (with large mortgages) who have not paid their mortgage payments (some are over $20,000 per month) for over  a year.

We have reported on numerous occasions how banks "doctor" their income and balance sheets to the point that no reasonable investor can depend on their financial representations.  The Bank of New York serves as a good example in how it uses "income from continuing operations" as its preferred public figure, because it has change the definition and construct of "income from continuing operations" for at least each of the last three years to make its operations look better.

While economic news has been playing up the increase in household net worth, if you look at debt and the deleveraging process, which has been on-going on the household level, you will see that households need to shed another $2.5 trillion in debt to return to 2002 levels.

Proper investing is about having a macroeconomic view and applying it to disciplined, rule based, fact driven investing.  Given the current national balance sheet recession and high unemployment and global economies, buy and hold investing is more difficult than short term investing where you limit your losses and lock your gains in.

The NFIB small business survey for December gained 1.5 points in November (up 2.7 in October) to 93.2 but is still in recession territory with no evidence of a surge.  Sales fell 2 points to <15>.  Reports of positive earnings fell 4 points to <30>.  It is still all about sales and sales are dependent on demand which is driven by economic growth and employment.

If China were to appreciate its currency, it would long term, after managing internal rebalancing, be the beneficiary and most other countries would be losers, including the United States.  The Australian economist, Bill Mitchell, took on the doctrinaire critics of China --- as in China is the problem --- and the focus on current account deficits which avoids the internal problems of an export driven economy, which has nothing to do with rather a nation is free or not but is directly related to the application, or the lack of application, of resources to internal imbalances.  Economic growth is not always a piece of cake.

Bill Black delineated how U.S. systemically dangerous institutions have not been regulated and in fact have blocked being fixed; how the systemically dangerous institutions of Ireland and Iceland became so large they dominated the regulators, the economy, and their governments; how the German systemically dangerous institutions have been allowed to be self-destructive, inefficient, and to fund destructive loans to Eastern Europe and EU periphery countries as if they were a drug cartel.  His conclusion is systemically dangerous institutions are too big to regulate.  This is why they need, in my opinion, to be broken up --- no matter how large or small they appear --- until the resulting units are responsive to proper risk management and regulation designed to identify systemic danger.

Bill Black has also recently written about how the deregulatory process (desupervision) of the Bank of England and its junking of the Financial Services Agency is sowing the seeds of the next UK financial crisis.  The BBC economics editor, Stephanie Flanders, has written the UK recent GDP numbers may be implying the economy is stronger than it really is, because construction has accounted for 40% of the GDP growth while only comprising 6% of the economy.  Construction output figures indicate it is growing at an annualized rate of 27% since April but the employment figures for construction have not risen.  This would appear to be inconsistent and indicate something is wrong with the data.  The UK has recently had some very notable revisions of economic data.  Is more forthcoming?  Meanwhile Parliament approved substantial educational fee hikes which have been the subject of demonstrations and riots.  These anti-austerity UK demonstrations are just a small part of the demonstrations going on across Europe

During this week ending the 11th of December, Germany continued to reject an expanded bailout mechanism.  Germany and France both declared they would not support the concept of a European bond, despite EU proposal by Tremonti and Juncker.  Wolfgang Munchau has commented in an analysis that the longer an E-bond is put off the bigger the crisis will become.  With the debt scheduled to be paid  by banks in 2011, European banks will be subject to challenges in filling big gaps beyond just winning the confidence of  bond and equity investors and beyond the borders of Spain and Italy, in both of which the banks are not as strongly capitalized as they should be. Italy has found European collateral guarantees in interbank lending to be so successful they began there own before the European version expired.

The bottom line of austerity, in a country which does not have its own currency,  is if you are left with only internal devaluation of wages and prices to spur the economy then you are setting up the necessity to reduce debt which can only be done by restructuring debt.

As the balance sheets of Ireland's banks became more apparent, they were facing further downgrades by the rating agencies and Ireland again iterated they could be for sell to sovereign wealth funds as the value of the euro deteriorated.   The reality was that the Irish banks were being sustained by loans from the Irish central Bank which were also coming from the European Central Bank to the point where the central banks exposure were at trigger points and even the most ardent proponents of European Union economic austerity were questioning  whether a bailout, which had become necessary, was being constructed in the best interests of Ireland.  Yet, with the imminent bailout, AIB (Allied Irish Bank), which is one of the two more solvent banks in Ireland, attempted to hurriedly make 40 million euro in bonuses at a bank whose value was 540 million euro.  Banks worldwide just do not get it.

The current eurozone troubles and Germany's failure to commit to common goals has had some observers, such as Marshall Auerback, theorizing what would happen if Germany left the eurozone.  It would create a strong Deutschmark which, however, would not be a reserve currency.  It would save the German banks but at the cost of its private household sector.  It would cause a trade shock within the eurozone as well as the world and lead to a drop of German exports, a dramatic slowing of economic growth, and a German budget deficit.

Bill Mitchell lambastes the European Central Bank boss, Trichet, for Trichet's ardent defense of austerity fiscal policies and his attempt to blame the current European economic problems on poor fiscal policy discipline of member nations, when the current crisis has been caused by an aggregate demand shock which exposed the flaws inherent in the lack of a fiscal mechanism within the European Monetary Union.  Mitchell questions why a blind eye has been turned to the criminal and/or incompetent behavior of individuals within the financial sector, why more austerity is demanded when it will depress growth, and why there is continued reliance on exports for growth which cannot be sustained or adequately developed.  In doing so, Mitchell asks who is going to pay for the economic hardship and lost opportunity of those who did not cause this crisis while those who did cause it get away scot-free.  These denials of the causes of the current financial crisis will only lead directly to the next financial crisis.

Pragmatic Capitalist points out that the European problems are indicative of the early stages of crisis, and not the later stages of crisis, as the result of denying there is a problem, denying there is a big problem, and denying the problem has anything to do with us, which characterize the three stages of delusion.  The ESFS emergency mechanism is flawed and invites speculative attack.  Simply raising more funds for an expanded ESFS will not be enough.  Pragmatic Capitalist draws comparisons to the current European crisis and the 1997 Russian currency crisis which expanded into the Asian Financial Crisis.  To solve the problems, Pragmatic Capitalist sees four options 1)Marshall Plan II, 2) Versailles Treaty II, 3) quantitative easing, or 4) the Icelandic option.  Of the four, Pragmatic Capitalist sees the first option as the best, because it would provide investment consistent with the development needs of each country, such as improved shipping ports in Greece to enable it to become a transportation hub between Europe and Africa and the Middle East, and such investment in the peripheral countries would also provide long-term benefits to countries like Germany.
I have long been a proponent of targeted investment as a means of promoting economic growth and correcting imbalances long-term within the eurozone.

Bill Mitchell discussed the importance of information in making informed decisions as investors and citizens.  As such, censorship of information, whether in China or the United States, is detrimental to informed participation in government, a denial of access to information, and a denial of freedom in which government is limited by necessity to be agents of the people and not our masters.  His discussion used the framing of information and public opinion in Europe as an example of how the European Monetary Union has been sold and is being defended by an elite who are not serving the best interests of citizens of the respective member nations.  His discussion then moves on to how the corrupt private financial sector in the United States is being protected and rewarded rather than being forced to confront the consequences of financial and foreclosure fraud as well as continued business conduct which poses a systemically dangerous financial risk to the world, while the current policy debate moves in the exact opposite direction away from the people.

John Hussman, in his weekly commentary on December 6th, said bonds do not warrant an extension of investment duration, the intermediate risks of gold are elevated, and the market conditions of stocks is continuing to deteriorate.  He continues to remain defensive, because stocks are overvalued, overbought, and overbullish combined with rising yield bond pressures.  He indicates one market investing rule is to not fight the market and he has revisited his different proprietary "climate" conditions to be more responsive and accept moderate, transitory exposures to market fluctuations.  If one looks at the projected 17 year annual return of the S&P 500 based on an average of three models he uses (forward operating earnings adjusted for cyclical margins, normalized earnings, and yields), the implied risk premium is only slightly over 1%.  Prior to the 1990's bubble it was closer to 5%.  Consequently, equity investors are accepting a duration which is three times that of a 30 year Treasury.

In a criticism of the Bernanke at the Fed, Geithner at the U.S. Treasury, and Trichet at the ECB, Hussman said, "We are allowing 99% of the world to accept budget cuts and austerity in order to defend bondholders from taking losses or having to accept debt restructuring. When bondholders lend money to a financial company or to a country, at a spread over the yield available safe debt, they are explicitly accepting the risk that the bet will not work out, and that they may lose money in the event of a restructuring. When government policy at every level focuses on making bondholders whole, then government policy at every level focuses equivalently on protecting the inefficient and dangerous misallocation of capital."

In discussing Social Security, Hussman said, as I have written, "My personal view is that the Social Security tax rate should be significantly lowered, but should apply to all income, wage and non-wage, while at the same time the income tax should be flattened. People at higher incomes would have a slightly higher total tax burden in the end, but lower marginal rates that would encourage work and discourage inefficient sheltering of income."

Hussman points out there are natural and useful counter cyclical argument to deficits that serves as automatic stabilizers.  Consequently, "Rather than targeting a balanced budget in the midst of a deep economic downturn (still more than 6% below potential GDP), we should be focused on policies that could reasonably be expected to achieve a deficit of between 0-1.5% of GDP at the point where GDP is again operating at potential. While I certainly think there is room to integrate unemployment compensation, earned income tax credits and Social Security in a way that strengthens the incentive for part-time work (I have friends with special needs who would lose all benefits if they worked even a few hours a week), I also believe that extending unemployment compensation is the smallest of our budget problems, and is a necessary response in an economy whose problems have been largely brought on by people at the highest income levels (particularly in the banking sector and Wall Street)."  Hussman concludes by saying, "The public is being abused for the sake of protecting bondholders that lent at a spread. This protection should end, or the resulting "austerity" will either weaken our defense or remove our automatic stabilizers."

On a personal investment level, I have been communicating current finance and economic research on the need to consider having the higher wage earning spouse waiting until full Social Security age to file for benefits and delay until age 70.  This option, among other Social Security filing options, needs to be seriously considered as the economic benefits can be substantial, particularly for the surviving spouse.  Evidently, more and more people have decided change their filing decision and delay until 70 and pay back benefits already received without interest.  This has caused the Social Security Administration to change the rules and only allow the payback of benefits when electing to change to delayed benefits.  Under the new rules, the claim for change of the beginning of benefits and delay can only be done within the first twelve months of their first Social Security check.  The withdrawal is limited to one per lifetime.  The election to suspend benefits is now only limited to future months with no payback of past benefits.  This makes it all the more important that the different Social security options be evaluated prior to the age of 62.

Market: 2 banks failed = 151 for year; the unofficial problem bank list is 919.

                 DOW/Volume                                   NASDAQ/Volume
Mon:         <19.90>/down 11.4%                        3.46/down 7.7%
Tue:            <3.03>/up 72.5%                             3.57/up 14.8%
Wed:          13.32/down 20.3%                          10.67/down 7.2%
Thu:            <2.42>/down 8.7%                           7.51/up 7.6%
Fri:              40.26/down 3.5%                            20.87/down 8.7%

Total           28.23                                                46.08

Mon: Oil up 19 cents to $89.38; Dollar stronger but weaker against the yen; Germany rejects larger European rescue fund; banks and discount retailers are down.

Tue: Oil down 69 cents to 88.69; Dollar stronger but weaker against the pound; much larger Dow volume is the result of institutional selling; Dow was up 1.1% during the day but sold off in the last 75 minutes in high volume.

Wed: Oil down 41 cents to 88.28; Dollar weaker but stronger against the yen; Treasury yields up on tax cut deficit fears; market see-sawed up/down; oil supplies were down 3.8 million barrels, gas supplies were up 3.8 million barrels, and distillate supplies were up 2.2 million barrels on the same day the price of gasoline locally jumped up 20 cents per gallon.

Thu: Oil up 9 cents to 88.37; Dollar stronger but weaker against the yen; 10 year Treasury yields fell 6 bps to 3.21%; auto parts, food companies, and financials led in mixed action; weekly jobless claims were down 17,000 to 421,000, 4 week moving average was down 4000 to 427,500, and continuing claims were down 191,000 to 4,086,000.

Fri: Oil down 58 cents to 87.79; Dollar stronger but weaker against the pound; volume fell across the board; 10 year Treasuries were up 31 bps to 3.33%.

United States: The U.S. Senate is considering stronger oversight of the Pension Benefit Guaranty Corporation as its deficit reaches $23 billion.  A recent Inspector General report raised questions about the ability of the PBGC to ability to cope with a new financial crisis.  The Employee Benefits Security Administration released a proposed rule to require all defined benefit pension plans to report annual funding to the EBSA.

Bank of America has told regulators it has raised enough capital this year to qualify for permission to make its last TARP payback.

New $100 bills with high tech security features are a printer's nightmare with 30% or more of the bills unusable as the paper folds during the printing process.  The printing has been halted as government is faced with going through $100 billion already printed by hand.  It would have been the first bill with Geithner's signature.

HSBC is being sued by the Madoff trustee for $9 billion alleging the bank had warning signs as early as 2001 and still remained a prime provider of feeder funds to Madoff.

Gasoline retail price is highest in 2 years (since mid October 2008).

The federal insider trading investigation has been ramped up.

Home Depot issued FY 2010 guidance revising net income projections to $1.97/share up from $1.94 and now expects revenue to be up 2.3% from prior estimate of 2.2%.

The Federal government is pressuring Fannie Mae and Freddie Mac to join the government program to reduce mortgage balances where borrowers owe more than the value of their home.  They have been reluctant to do so, particularly if borrowers are still making payments.  If they participate the written down mortgages could be handed off to the FHA just as private banks, who participate, can.

Bank of America agreed to pay $137 million in restitution for municipal bond bid rigging.

U.S. Treasury sold 2.4 billion shares of Citi at $4.35 each with the last share sold on Tuesday.

Citi hired former Obama Administration Budget Director, Peter Orzig, to be vice-chairman of its investment bank division.

Morgan Stanley has been sued by MBIA over claims made by the bank regarding MBS it sold; "made false representations regarding the underwriting standards".  MBIA may be considered indemnified by the Pooling and Servicing Agreement and Morgan Stanley may not have set aside reserves for this purpose.  The pool is composed of approximately 5000 securities rated AAA, which are subordinated-lien residential mortgages upon which MBIA has already paid $71million in unreimbursed claims.

The U.S. trade deficit went down to $38.7 billion in October from $44.6 billion in September (expected 43.6 billion); exports were up $4.9 billion and imports were down $900 million.

U.S. household net worth was up 2.2% Q3 as borrowing and credit card use fell.

Foreign central banks holdings of U.S. securities were down $5.68 billion for the week ending December 8th; Treasury holdings were down $2.87 billion; mortgage securities holdings were down $2.81 billion.

U.S. Treasury may be planning to sell approximately $15 billion of AIG shares in 2011 which would cut its stake 20% from 92.4%.

GE is raising its dividend 2 cents to 14 cents (17% up) for the second time this year (2 cents in July).

TJX (TJMaxx, Marshalls) will cut 4400 jobs as it shutters 71 A.J. Wright stores and converts 91 stores to either those two formats or the Homewoods format.

Bank of America refiled 16,000 foreclosures this week in both judicial approval and non-judicial states.

Mortgage rates hit a six month high of 4.61%.


According to the Fed, household real estate values declined $684 billion in Q3
U.S. wholesale inventory in October was up 1.9% --- expected up 0.8% ---(September revised to up 2.1%) and October wholesale sales were up 2.2%.

ECRI Weekly Leading Index rose to <1.5> from <2.4>.

Tobin's Q Ratio has moved into nosebleed territory with the market overvalued by 59% using the arithmetic adjusted method and 72% using the geometric adjusted method.

U.S. Treasury auctions:

3 year Treasury, $32 billion, yield .862%, bid to cover 2.91, foreign 36.7%, direct 18.0%.

10 year Treasury, $21 billion, yield 3.340%, bid to cover 2.92, foreign 44.4%, direct 11.4

30 year Treasury, $13 billion, yield 4.410%, bid to cover 2.75, foreign 49.5%, direct 8.13%.


International: Bank of Canada kept its interest rate at 1% citing weak exports and global risks such as the European Monetary Union.  Bank of Canada said the European crisis could have adverse effect on other countries including Canada and the risks to Canada's financial system are up in the last six months.

S&P raised the debt rating of Latvia one step to BB+ with a stable outlook.

Moody's cut Hungary's debt rating one notch to just above junk and warned of more cuts if Hungary's budget deficit is not reduced.  Hungary rejected austerity and intends to impose taxes on bank and other businesses as well as tap pensions.

German exports in October were down 1.1% with imports up 0.3% to a record high of 72.6 euro.

German production was up 2.9% in October (down 1% in September) -- expected up 1%; output was up 11.7% adjusted for days worked; factory orders were up 1.6% in October.

Russia and the European Union are near a bilateral trade agreement which may pave the way for Russia to join the WTO.

The Australian Central Bank held interest rates at 4.5%.

Australian employment was up 54,600 in November exceeding the estimate; unemployment was down to 5.2% (5.4% in October); the participation rate was 66.1% which is a record; employment is over 11,000,000 for the first time.   For a more in-depth analysis make sure you review the Bill Mitchell comments on Australian unemployment linked to above in this weekly commentary.

New EU bank stress tests on 91 banks have been ordered for July.

Japanese GDP Q3 was revised to up 1.1%.  Weak economic data indicates Q4 will contract to an estimated <0.1%>.  Annualized growth is at 4.5%; capital spending Q3 is up 1.3%; personal consumption is up 1.2%.

Bank of England kept interest rates at 0.5% and made no change in monetary policy, because it wants to wait and see the effect of the government's austerity program on economic growth next year.

Fitch downgraded Ireland's debt rating three notches to BBB+.


Ireland is planning a 90% tax on banker bonuses.

China raised banks required reserves for the third time in a month by 50 bps to 19% for its largest banks.

China's auto sales were up 27% in  November.

Bank of Korea kept its interest rate at 2.5%.

Britain's trade deficit increased 1.6% in October, which was unexpected; imports hit a record high.

UK producer prices were up 3.9% in November vs year ago, which was less than expected.

Canada's trade deficit was down 39% ($ 0.6 billion to $1.7 billion) in October (more than expected) as exports of copper and precious metals rose.

French industrial production was down 0.8% in October, which was more than expected; Italy's was down 0.1% (down 2.1% in September); Germany's was up 2.9%.

Spain began a 5 year $111 billion program to make its industries more competitive.





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